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Reggie Middleton on the Recent Ackman Short - Realty Income "O"

Reggie Middleton's picture




 

We have taken a 2nd look at the concerns raised by Ackman now that we
have a copy of his short thesis on Realty Income (O) in PowerPoint (pdf ackman-realty-income-short 21/10/2009,14:14 645.84 Kb)
and have come up with the following observations. For those who do not
subscribe to my blog, I have decided to make a significant portion of
my real estate analysis available to the public, so as to fully
communicate the apparently unforeseen cash flow and valuation
situations of some of these REITs. This is in anticipation of a slew of
fresh REIT short candidates to be delivered to subscribers in the
upcoming weeks. I feel the sector is ripe for a revisiting in terms of
valuation, cash flow issues and macro outlook. For part one of my
review of Ackman's "Realty Income (O)" opinion, click here (requires a quick, "free" registration): Realty Income Preliminary Review Realty Income Preliminary Review 2009-10-08 01:27:59 1.35 Mb.

 

To begin with, I have taken an earlier look at Realty Income, and while
I agree that they may not be in the best shape and do not have strong
macro prospects, I didn't see an absolute case for a short. I was then
forwarded the full presentation given by Ackman, in which I was able to
review more of his reasons for the short thesis. The following are my
findings, followed by a detailed analysis of another REIT that,
although may not be facing as stringent a macro dilemma, has a much
more pressing cash issue at hand. Before we get to that, let's go over
my second (albeit still relatively and admittedly cursory) review of
the Ackman "O" short thesis. Keep in mind that Ackman and his crew
probably took more time to review "O" and interact with its management
than I did.

Overvaluation - The Company is trading at significant
premium if we compare the Company's enterprise value per sq feet, which
is $215 per sq, with the average rate at which Realty Income's
available for sale properties are listed, which is $116 per sq feet.

However, since the sample (available for sale properties) is very small
in size (52 properties) relative to Realty Income's total property
portfolio (2338 properties), it may not accurately depict the fair
average  rate to be used to value whole of Realty Income portfolio.
Also, the specifics (location, occupancy, business type) of the
properties available for sale are likely to be substantially distressed
in comparison to the Company's total property portfolio.

 
o_overvaluation.png

  • Retail cap rates -
    Retail Cap rates are on a rise and as per CBRE, the average retail cap
    rate in US increased 59 basis points to 8.71%. Further, single tenant
    stand alone properties that the Realty Income owns are trading at high
    cap rates reflecting the high tenant risk. Management too, while
    discussing the acquisition opportunities in 2Q09 conference call,
    mentioned that cap rates are on a rise and could reach 10% territory.
    However, the 10% cap rate levels reflect the distressed retail property
    market and it is a slightly unrealistic to apply similar cap rates to
    value all of the Realty Income properties which may include properties
    which are mortgage free, [error correction as pointed out by commenter below]  occupied and functioning as per lease
    agreements.

We have created the following matrix, to demonstrate the sensitivity of
Realty Income's share price to change in cap rates and NOI. Realty
Income's net operating income on TTM basis was $322 million.

o_cap_rate.png  

  • Tenant Quality -
    The Company's exposure to middle market retailers -is a cause of
    concern - since the segment stands out to be quite vulnerable to
    economic downturn. The Company does not report the names of the major
    tenants and therefore it is very difficult to identify the specific
    retailers and the estimate the Realty Income's troubled exposure. As
    per Company's last filing, its largest tenant - Buffet Holdings-
    accounts for 6% of the total rental revenue. The second largest (not
    named) accounts for 5.4%. The top ten and top fifteen tenants comprise
    about 40% and 53% of the revenues, respectively. For the top 15
    tenants, the EBITDAR to rent coverage on an average was 2.46x and
    ranged from 1.55x to 3.59x.

However, the Company reports the tenant details in cases of Chapter 11
bankruptcies. Looking at specific instances reported by Company in the
filings, their largest tenant - Buffet Holdings accounting for 6% of
the total rental revenue - filed Chapter 11 Bankruptcy in Jan 2008 and
emerged from reorganization in April 2009. Following reorganization, of
the total 119 properties leased, 14 leases were terminated, while
remaining 104 were re- leased with 13% cut in rents. Buffet holdings -
restaurant owner - remains distressed and is selling properties at cap
rates of about 11%.

Another tenant - Big 10 Tires filed for Chapter 11 bankruptcy in
April 2009 and emerged from reorganization in July 2009. As per
Company, they accounted for 2% of rents and occupied 50 properties.
Following reorganization, two leases have been terminated while 48
properties have been re-leased with about 15% cut in rents.

Based on experience over the last one year, the Company states that
the average hit on rent resulting from re-leasing in case of bankruptcy
is generally around 15-16%.

In the 2Q09 conference call, concerns were also raised about some 24
properties leased to Rite Aid and some properties leased to Bally's,
but the management did not divulge any information regarding the same. 
Also, it is very difficult to identify the amount of rental revenue
that Realty Income derives from these tenants.

  • Reduction in future cash dividends
    - We conducted an analysis of the impact of possible reduction rental
    revenue on cash flows and the probability of cut in cash dividends. We
    have, based on probable reduction in occupancy and same store rentals,
    have assumed (a rather pessimistic assumption of) 10% annualized
    decline in rental income in 2009 and 2010 going forward. Therefore, we
    assumed 5% decline each in 2H2009, 1H2010 and 2H2010. This translated
    into rental income decline of $8.2 mn, $7.8 mn and $7.4 mn for the
    above mentioned periods, respectively.

 

Rental Income (in $mn)

 

1H2009 (Actual)

2H2009 (estimated)

1H2010 (estimated)

2H2010 (estimated)

Rental Income ($ mn)

$163.65

$155.5

$147.7

$140.3

Percentage decline

 

-5%

-5%

-5%

Decline (in $ mn)

 

$8.2

$7.8

$7.4

 

Assuming (most pessimistically) that the entire decline in rental
income trickles down to the bottom line, the projected cash flow
statement for the above periods will be as reflected below:

o_cash_flow.png

It can be seen that even with the most pessimistic assumption of 10%
annualized decline in rental income in 2009 and 2010 henceforward
(along with the assumption that the entire rental decline impacts the
bottom-line), the company would be in need of cash only by end of
2H2010. With its revolving credit facility which the Company can easily
use, this deficit can easily be taken care of. This means that the
company can continue to pay distributions to its shareholders at the
current rate without even having recourse to borrowing facilities.

Assumptions for the above cash flow projections are:

1)     Rental income decreases 10% on annualized basis in 2009 and 2010 (starting from July 1, 2009)

2)     Entire decline in rental income trickles down to net income

3)     The company doesn't make substantial investment in acquisition
of new properties, nor does it sell its properties to receive
substantial inflows

4)     The company would maintain the current rate of distribution to its shareholders

5)     There will be no prepayment of loans (which are due only after
2012 as per company's debt repayment schedule disclosed in its last
filing)

 

Keep in mind that I normally review and value each and every
individual property a REIT owns or even has a partial interest in. This
usually yields a very different result then that which is reported to
the SEC as book or carrying values. See " GGP and the type of investigative analysis you will not get from your brokerage house"
for a prime example. The Macerich analysis also provided equally
revealing results, which I will probably be revisiting soon (requires a
quick, "free" registration):

I believe that the latest subscriber REIT actually has a significantly
more stringent cash flow problem in that even if it does cut its
dividend (which is a no-no for REITs) it still will not be able to
cover its cash requirements and will have to seek additional capital.
Unfortunately, as the market has skyrocketed away from any adherence to
fundamentals and basic math, the sell side shops and particularly those
who may have had some suicidal debt exposure to the REITs in question
have successfully converted the bad debt of REITs to bad equity and
sold it off to unsuspecting investors who do not read or subscribe to
my blog.

This has, essentially, kicked the can down the road and potentially
set up said banks for litigation. Although the REITs have been able to
equitize bad debt, and more amazingly, offer stock in lieu of cash
dividends (imagine cash income investors voluntarily accepting more of
a stock as a dividend of a company that can't afford to pay the cash
dividend that you invested in the company for),:

  1. rents are deflating rapidly practically across every category and sector
  2. delinquencies are up sharply and growing
  3. CMBS default are rising quickly
  4. Valuations are down across the board as cap rates spike
  5. practically
    the entire real estate industry binged between 2003 and 2007, with the
    05 through 07 financing vintages ending up as literal garbage across
    the board

Sales are extremely buyer orientated and slow due to banks unwilling to
finance and bid/ask spreads bordering ludicrous because of the amount
needed to cover encumbrances vs the amount needed to enter into prudent
and profitable deal. In addition, there are some who are vulture
feeding now, but I believe real estate has a ways to fall. It was a 7
year climb in residential and a 4 year climb in commercial (arguably
more, but interrupted by 9/11 and the burst of the dot.com bubble),
built upon unprecedented financing rates and credit availability fraud.
It is highly unlikely this will unwind in 2 and a half years. 

Since I am moving on to find additional profitable positions in the
overleveraged and over valued REIT industry (an industry whom I feel
may have just used up the reprieve purchased by equitization of bad
debts and charlatan conveyance of incomeless stock as income
dividends), I am releasing the American Campus Communities analysis to
the public. This is a company that we feel is truly in a cash bind, ala
GGP, simply to a lesser extent. Its share price has benefited immensely
from this latest bear market rally, and it has also managed to keep its
rental rates firmer, longer than we expected, but at the end of the day
rentals are softening and the cash flow situation emanating from
over-priced acquisition binging during the bubble is catching up to
them.

You will have to select the "free" registration
option to download the reports. I should have the new REIT bear thesis
fleshed out in a week or so, and the entire portfolio independent
valuation and analysis about a week after that for paying subscribers.
In regards to ACC, it should be known that they, like nearly every
other REIT that has not already filed for bankruptcy, have benefited
immensely from the stock market rally. This should not be confused with
the fundamentals. Problems are still problems, regardless of whether
momentum traders drive your share prices considerably above where it
belongs or not. This should go without saying, but I am aware it has to
be pointed out to a select few. The most recent update is at the bottom
of this list.

ACC 2Q09 results review ACC 2Q09 results review 2009-08-12 01:25:50 110.50 Kb 

American Campus Communities Summary Preview - Pro American Campus Communities Summary Preview - Pro 2009-03-09 00:40:22 436.84 Kb

American Campus Communities Property Analysis American Campus Communities Property Analysis 2009-03-26 23:28:27 19.56 Mb

American Campus Communities (ACC) Forensic Summary American Campus Communities (ACC) Forensic Summary 2009-03-23 00:21:15 538.57 Kb

ACC Summary Professional Addendum ACC Summary Professional Addendum 2009-04-01 14:30:07 292.43 Kb

ACC May 2009 Intelligence Note ACC May 2009 Intelligence Note 2009-05-04 11:59:26 414.74 Kb

ACC First Quarter 2009 Results ACC First Quarter 2009 Results 2009-04-30 12:27:03 381.58 Kb

ACC Intelligence Note - Q1 2009 update ACC Intelligence Note - Q1 2009 update 2009-06-24 01:32:30 289.92 Kb

ACC 2Q09 results review ACC 2Q09 results review 2009-08-12 01:25:50 110.50 Kb

ACC 9-09 research note ACC 9-09 research note 2009-09-24 12:31:24 1.03 Mb - this is the most recent update on ACC.

 

 

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Fri, 10/23/2009 - 08:40 | 108056 badgerman67
badgerman67's picture

Thanks for your reply Reggie, I cannot resist a good debate too.  Always better to demand a higher yield than a lower one.  It might under value it, just depends on how aggressive you want to be in your underwriting.

Its really a return vs valuation issue.  In your analysis you referenced specific tenant issues with their property which is fine.  Cap rates are market based not property specific and they are looked at both on an actual and market basis.  Looking at only actual cap rates doesn't necessarily give you accurate output.  Definitely will take a look at your GGP analysis.

To be certain there are concessions in most if not all of the leases for Realty Income.  Going forward 60 day build out plus 2-3 months free which is probably aggressive gives you 6-8% decline in their gross rent as stated. Reality is it will be much worse.

Fri, 10/23/2009 - 04:24 | 108002 badgerman67
badgerman67's picture

No I said you deduct the income you assume to be at risk from the capitalized value.  Think about it another way.  Assume the market is booming and there are tenants everywhere looking for space.  You buy a building with a tenant on the verge of going BK.  What cap rate do you apply?  The answer is you apply the market rate and reduce the purchase price by your absorption assumption costs going forward.  If you accounted for that tenant by applying a higher cap rate you assume the below market condition exists in perpetuity.  It does not.

All that aside the real problem is you cannot really underwrite with direct cap rate analysis in this market.  And no you do not change your cap rate for a tenant specific issue because that assumes the issue exists in perpetuity. You would apply a higher vacancy/credit loss or as I said you could discount the value of the income you believe to be at risk and deduct from your capitalized value.  It's really a valuation issue and your methodology is not exactly correct but you probably are close enough that its not a major issue.

By assuming only a decline in rents you do no account for vacancy and therefore cap ex items that are below your NOI.  And as I stated earlier CAM recovery is pro rata.  If your anchor tenant(s) vacate your impact on NOI is much greater than a simple reduction in top line rent.  If the anchor space stays dark longer than the early termination clause that exists in most retail leases your center is toast.

Fri, 10/23/2009 - 06:44 | 108026 Reggie Middleton
Reggie Middleton's picture

But your assumption does not apply in the situation and single tenant properties go for higher cap rates than multi-tenant properties for the reasons I explained. You sound like a smart, knowledgeable guy and I don't really have the time to go back and forth (particularly since I really can't resist a debate either), so I have to cut this short.

We never assumed only a decline in rents, but we do feel that Ackman's presentation is a little aggressive in its assumptions. That doesn't mean they are not right, just a litte less conservative than me and my team are use to using. We account for vacancy, bad credits, etc. Take a look at the portfolio modeling sample from the GGP link, it is compreshensive.

I understand your point, but by reducing the price as you described, you essentially closed the deal at a lower cap rate. You can call it whatever you want, but the yield you demanded for the risks going forward are higher. Suppose the tenant straightens up and pays as agreed for the balance of the lease term, say 20 years. Have you not now under valued the property with your 20 year forecast? No matter what adjustments are made after the transfer of the property, you demanded a higher yield. tomato, tomoto :-)

 

 

Fri, 10/23/2009 - 06:44 | 108028 Reggie Middleton
Reggie Middleton's picture

I meant higher cap rate

Thu, 10/22/2009 - 23:58 | 107872 Anonymous
Anonymous's picture

This company sure has some pretty crappy tenants that represent a big chunk of revenue. Drek !

Thu, 10/22/2009 - 17:19 | 107348 badgerman67
badgerman67's picture

Hi Reggie, I was the anon that posted above.  Sorry did not have a name yet.  So ok now I read it all.

"Further, single tenant stand alone properties that the Realty Income owns are trading at high cap rates reflecting the high tenant risk."

Cap rates reflect markets not specific tenant issues.  If the tenant is a risk you discount the rent (at whatever discount rate is deemed appropriate) and make the adjustment to your capitalized value.

I think you underestimate a decline in rents as it will impact more than NOI.  Since you are likely to see vacancy spikes this will lead to below the line (NOI) costs including LC (leasing comm) and TIs (tenant improvements) costs.  CAM recovery is pro rata so reimbursement of operational expenses will likely also be impaired.  I have not looked at their portfolio so not sure what % of their portfolio contains community, neighborhood centers,  and/or malls.  If the anchors go the in-line space typically has a right to vacate after a specified period of time.  The anchor lease(s) may also allow early termination if one anchor vacates and the space is not re-leased in a specified period.  I am sure you do not have to go far to see a vacant center these days.

As for single tenant box space, good luck.  That can stay vacant a very long time and reconfiguration is tyically not feasible.

 

Fri, 10/23/2009 - 02:37 | 107979 Reggie Middleton
Reggie Middleton's picture

Single tenant property leases have a high overlap with market risk and by extension higher cap rates that reflect the overall yield required by the investor on the risks assumed. With single tenant properties, you cannot adjust a lease rate mid lease (outside of the bounds of the contract) and since there is only one soure of rental revenue there is no staggered renewal, hence the value of the property changes to reflect the condition of the single lease holder (even if that lease holder has paid as agreed to date) which can often reflect the condition of the market as well but not necessarily so, hence cap rate fluctuation (it appears that is a version of what you said). If your single tenant property has a tenant that is in trouble, and you sell it with X years left on the lease, it should trade at a lower overall value (and higher cap rate) because of the risks involved. You cannot raise the rents to subsidize the risk, hence you lower the transaction price. You said you discount the rents, but if the rents are currently being paid while the transaction goes through the deal executed at a higher cap rate, no?

I don't think we are undersestimating the decline in rents, for they can be modeled out easily enough (look at the modeling performed on GGP and MAC properties) but I do appreciate your point. We can't model the siutation out because O won't reveal their portfolio. That is one of the strongest points in the short thesis. I also don't think O is necessarily a bad short, it is just that their cash situation is not an immediate issue. More pressing is the fact that they are so secretive with thier portfolio. You don't hide something you are proud of. I am sure they are carrying their book above value, but that is a game that they may be able to do for some time until they are forced to realize market values.

ACC has more pressing cash issues at hand that they can't paper over.

Thu, 10/22/2009 - 16:36 | 107285 Anonymous
Anonymous's picture

Trying to tackle REITs is such a daunting job because of the counter-parties involved.

One or several own the land, one or several own the building, one or several manage the property and most are private.

With all either dependent on the fate of the others, or willing to take a loss so as to re-enter later at a better price, while at the same time reducing the competition, it's tough to figure out all the angles.

Just look at GGP. By going in early they will probably come out of bankruptcy at an opportune time to capitalize on the demise their wake has caused on all the weaker players. Who cares if all the stock/bondholders/tenets were also wiped out? GGP keeps the cream and flushes the milk. Then, a nice clean IPO can instantly raise several billions and the game starts all over. It's not like they will come out of bankruptcy not still owning 5 of the 6 malls in Las Vegas.

As an aside, here's a nice article that details the nations' most troubled properties:

http://www.costar.com/News/Article.aspx?id=2E9CE212C74324BBFD158D3101C64D03

Thu, 10/22/2009 - 15:00 | 107140 Anonymous
Anonymous's picture

I remember when you called out GGP. Look forward to your opinions further. FRT, MAC, SKT, SPG might be excessively priced.

Thu, 10/22/2009 - 13:07 | 106964 Comrade de Chaos
Comrade de Chaos's picture


Reggie, I am too lazy / don't want to get upset over going over books of anything financial. Still I am dying from curiosity so is there a way you could answer the question below? Any input of luck of thereof is appreciated.

 

"Wells’ profit of $3.2 billion, or 56 cents a share, beat expectations, but Bove noted that the bank earned a stunning $3.6 billion from a hedging strategy related to its mortgage-servicing rights -- a gain that may be difficult or impossible to repeat."

who was on the other side of hedge?

Thu, 10/22/2009 - 16:54 | 107312 Miles Kendig
Miles Kendig's picture

Still searching CdC?   If there is a program to shift this exposure to the public sector perhaps we should look at the FHLB system or the GSE's.  Just a WAG tho.

Reggie, Green, panda?

Thu, 10/22/2009 - 11:40 | 106848 Anonymous
Anonymous's picture

Agree with the initial premise but your research should probably start with the definition of a cap rate as it applies to real estate. Then again,static analysis in this market will likely produce a distorted valuation.

"slightly unrealistic to apply similar cap rates to value all of the Realty Income properties which may include properties which are mortgage free, occupied and functioning as per lease agreements."

Did not read much past this statement. To start cap rates are all cash returns so leverage is irrelevant in the determination of a cap rate. By the way so is lease expiration exposure.

Thu, 10/22/2009 - 15:22 | 107175 Anonymous
Anonymous's picture

"Did not read much past this statement. To start cap rates are all cash returns so leverage is irrelevant in the determination of a cap rate. By the way so is lease expiration exposure."

I think what he was saying is that debt free properties is what you want to be holding right now. Why would you sell a debt-free project in this environment unless you can sell it for a low cap rate? Therefore, the value to the company is higher than that of a similar project that is levered.

I understand your point, however I think there's merit in his statement.

Thu, 10/22/2009 - 15:04 | 107143 Reggie Middleton
Reggie Middleton's picture

Maybe the problem is that you stopped reading! Your right in that the inclusion of the word mortgage is misleading but the statement is still accurate. There is no reference to lease expiration exposure. It is misleading to apply a general cap rate to a potentially diverse set of properties, some of which may have higher quality, better paying tenants and better performing leases. This is why my preferred methodology is to value each property separately which can't be done when managment hides the properties. Methinks you may have missed the point when you stopped reading.

Thu, 10/22/2009 - 11:37 | 106843 Anonymous
Anonymous's picture

Agree with the initial premise but your research should probably start with the definition of a cap rate as it applies to real estate. Then again,static analysis in this market will likely produce a distorted valuation.

"slightly unrealistic to apply similar cap rates to value all of the Realty Income properties which may include properties which are mortgage free, occupied and functioning as per lease agreements."

Did not read much past this statement. To start cap rates are all cash returns so leverage is irrelevant in the determination of a cap rate. By the way so is lease expiration exposure.

Thu, 10/22/2009 - 10:46 | 106768 Anonymous
Anonymous's picture

Thanks, Reggie. Please keep it coming.

Thu, 10/22/2009 - 10:39 | 106754 gr8t4ever
gr8t4ever's picture

Good presentation makes alot of sense but is it really Pershing Square's?  Why would they make this information public.

Thu, 10/22/2009 - 09:32 | 106679 spanish inquisition
spanish inquisition's picture

Good work. Lots to review. When a tenant is distressed but has not filed, it is pretty common to offer and write up a 1 month "rebate" to maintain the rental rate and gross rental income. Knowing you are going to take a hit on cap rates, it would make sense to someone to front load value. It could be either expensed out or put to deferred income depending on how you write it up. Any evidence of that here? I haven't been through the in depth stuff yet.

I am not saying anything about any accounting improprieties, maybe I am a little cynical. I just think its getting to the point where instead of going to Vegas to see a magic act, they will have an accountant on stage with an overhead and people can sit in the audience and go "ooohhh" and clap wildly.

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