BPO Properties REIT Conversion

BPO Properties, a public subsidiary of Brookfield Properties at 89%, will convert to a Reit in April 2010. The transaction does not really change the economics of Brookfield, however its implications are more subtle. Please note that I own Brookfield Properties.

1. Brookfield Properties will follow the same game plan of Brookfield Asset Management (BAM), its parent, by creating ownership structures floating them and earning management fees from them. Not only Brookfield Properties will de-leverage its balance sheet, which it badly need, but will establish high Return on equity revenue stream.
2. BPO Reits will be sold to less than 50% by Brookfield in the future as Brookfield will not want to consolidate debt of the Reit. Also conversion to a Reit mostly will benefit retail investors rather than corporate subsidiaries, as dividend income flows between corporation tax free.

Given that I am not sure why BPO Properties shot up 10% on the announcement? There will be more supply of BPO shares in the future and higher cost structure given all the fees the Brookfield Properties will earn from them.

A Bid for Illiquidity

Back in November 2008 to January 2009 buying decisions were fairly easy. There was all kinds of opportunities to choose from. All you had to do was step up to the plate in any asset class or in any market and take a pitch. Right now buying any asset is not so easy. Credit and equities are fairly valued. I have not find anything of interest. I spoke about few ideas but nothing interesting materialized.

To find a good pitch I have to find a market where the level of professional analysis is a bit lower. So I will have to avoid the US markets. That means I have to find illiquid assets. That is fine by me. Liquidity is not worth a cent in my book. So I found the Canadian Debentures. Those are subordinated and unsecured, in some cases, debt instruments issued by companies of lower credit quality. I have sifted through dozens of these names and I have found two ideas. I tried to establish a position in both but I was unsuccessful and the price ran to the point it is no longer attractive to me, and that is why I am writing about them now.

Royal Host 2013 6.25% Debenture (RYL.DB.C)

Royal Host is a hotel owner and operator in Canada. It owns and operates economy hotels mainly in Ontario and Western Canada. I do not need to go into the hotel industry fundamentals as they are atrocious right now. It is worth noting that hotels performance is tied closely to the economy. But this is not a bet on the economy, it is a wager that I will get paid in 2013 at 100 cents on the dollar while purchasing the debenture at 68 cents on the dollar.

I have been stalking this issue for awhile but the price ran from me from $68 to $80 at the close Friday. I am no longer interested at that price but if it dips down I will try again. What makes it worthy? The issue is distressed debt in the hotel industry, where debt is selling at 68 cents on the dollar. If hotel vacancy and rent per room are stable at current level which is bottom of the cycle then debt is over collateralized at cap rate up to 11.5%, extremely low valuation even in the hotel industry. The Company have several liquidity generation abilities and should fund its obligation and debt maturities with no issues. The debenture offers the potential to generate IRR of 27%.

If you bought the issue at 68, the company will have no problem repaying you at 100 cents on the dollar even if cash flow from operations after debt service is negative, according to my analysis and valuation. The company have several options to generate funds:mortgage assets that are free and clearsell a sizable marketable securities portfoliocut its dividends
The only issue here is the company stock buybacks. The company is using its available funds and selling its portfolio to buy back its shares. It had tendered for 26% of its shares in December and going back for more in Jan 2010. Why is the company doing this while it cash flow from operation can barely service its debt. The answer is it may be setting up for going private transaction.

The company is 25% owned by Clarke Inc and its board are mostly controlled by Clarke. After the tender Clarke ownership will jump to 37% and potentially more after the additional tender offers by the company. Clarke obviously wants to take private Royal Host with little cash outlay on its part, particularly that Clarke's balance sheet is in worse condition than Royal Host. If the privatization takes place sooner than maturity the debentures will be redeemed at 101 cents on the dollar. However if the tenders keep coming it will compromise the collateralizing of the debt.

Still at high 60s or low 70s I think the issue is worth the risk. But now I will bite my time until either it comes down in price or look back and see how pretty my spreadsheets look like.

Next post I will tackle the second idea.

IFRS implementation in Brookfield Properties

Brookfield Properties (BPO) will adopt IFRS, new accounting standards that most US and Canadian companies will transition into, ahead of schedule according to their press release. You will see most real estate operators opt to adopt IFRS early, particularly those with properties acquired more than 5 years ago. That is because it will decrease their leverage and increase book value.

IFRS allows companies to adopt fair value measures of their assets. It is advantageous for owners with older properties to account under IFRS this way their leverage ratio will be much better. Also I think in this cycle where commercial real estate have been clobbered you will see many years in the future of up revaluation of properties and steady increase in book values.

The accounting changes will move BPO book value from $9 to about $14 making Price/ book value less than 1.

Also they will be compare more favorably now that leverage is reduced. Most analyst do not like BPO because it has higher leverage ratios compared to other office owners.

Commercial Real Estate: Some Observations

I have taken a beating on my commercial real estate holdings (CRE). So it is time to reevaluate my position on the sector.  

My original buys of these names were in late 2008 on the premise that unlike previous down cycles in CRE, office real estate is not overbuilt and will not experience any thing close to late 1980 collapse in prices. I guessed that the market had overreacted to CRE and the market though a repeat to the  collapse in residential housing will occur in CRE.  I expected cyclical down pressure on their operation to be mundane. You can see my earlier views here:  post 1, post 2, post 3, post 4.

What is the status of CRE, here are few observations:

• Credit underpins the valuation in all capital markets, including commercial real estate. To that extent lack of credit have downward pressure on CRE prices. The fact that CRE did not overbuild dampen that downward pressure.
• As deleveraging occurs, credit for CRE will not be available. Private equity and investors are not rushing to pour money into CRE.CRE upleveraged and needs to deleverage, while debt value are constant it follows that asset values came down so equity is wiped out.
• As property owners have no equity in their holdings they have no incentive trade or sell their assets. They will hang on in hope of something to happen. For example, GGP did not want to trade with Simon Property even in bankruptcy because they do not gain on these sales, so they will hang onto their properties in bankruptcy in hopes of something happening.
• No transaction will occur for few years so valuation will not be visible. Valuation will decline but will be mundane at least in what is reported in indices. 
• Transaction will occur in two instances:
• loans come due and the majority will occur in 5- 8 years. Lenders will extend loans rather take loses.
• transactions will occur when there is growth prospects of leasing, rental agreements..etc. so far the prospects of performance is not visible so highly likely no transactions to occur.

• The 20% drop in values are for small properties and not indicative of values in CRE space. publicly traded CRE companies have gone some 55-60% may be that is more accurate for CRE values.
• REITS that have announced equity sales have gone up and when completed have gone up even more. These REITS Ent. value has expanded as it reduced its debt/ equity ratio. Raising more equity will increase value rather it will dilute ownership as earning are decompressing.
• office will hit hard as unemployment will be high for few years so demand will go down although no overbuilding happened. 
  

Am I to abandon the space? I think not. But I will reduce some exposure as I take advantage of this rally. There are interesting development in some areas that can lead to opportunities especially on debt and distressed debt front. Still my preference is to buy long term assets in supply constrained markets, Like Brookfield Properties and Boston Properties. 

General Growth Properties Bankruptcy

This is one of the biggest bankruptcies in commercial real estate history; Olympia & York is close second. This is also one of the most complex as well. The company is operating relatively well but is being crushed by a mountain of debt that can't be refinanced. Their operating metrics are not stellar but they are not bad either. 

Bill Ackman, the famed hedge fund manager, have bough into all levels of the capital structure. His fund not only bought sizable portion of the common but only some senior debt and he is the Debtor In Position financier. Many retail investors have been following him by buying the common. The question is: is there value in owning the common shares? 

Examining the most recent supplemental and 10K, we find 2008 total NOI (Net Operating Income) of $2,576.51M. Assuming a 5% decline in NOI in 2009, our NOI estimate is $2,447.2M. The 5% is realistic for two reasons: 

1. their more recent quarter have seen their NOI drop by 4% from 2007 quarter and 
2. The retail environment have gotten worse since the Q4 of 2008 with sever retail sales declines in Q1 2009  
   

To calculate the value of GGP we use potential cap rates that are appropriate in this environment. I think a range between 8-10% is appropriate. The value of commercial real estate is simply NOI/ Cap rate. Under the different cap rate the potential value for GGP is as follows:

	8%	9%	10%
Value	30,587	27,189	24,470
Add: Other Assets	3,833	3,833	3,833
Less Liabilities	30,500	30,500	30,500
Value per share $	12	2	-7

So unless market cap rates go up beyond 9.5% then there is value in the common equity. However there are many other considerations:

• The bankruptcy will be a long process which most retail investor do not have the attention span for.
• complex and not transparent process.
• GGP's debt is owned by many CMBS holders that might not play ball like large lenders and could negatively affect the outcome of restructuring. 
• Equity holders have no voice and no ownership in CH 11, so GGP's bond holders can strike deals that may wipe out equity regardless of value.
• Legal fees and other bankruptcy fees will eat a lot of the cash generated from restructuring. Lehman Lawyers so far have reaped over $ 150 million. The fees alone can wipe out any value for the commons. Some other bankruptcies like Enron costs more than $250 million. 
• Bill Acman can make good return on his debt even if the equity is wiped out so he is different from you and I owning only equity.
• The game of distressed investing is a different ball game and require set of skills and legal expertise that many of us do not have.

So GGP may have value but the margin of safety and parameters are out of the scope of my competence. And if this is the same for you you should stay away.

NorthStar business model re-evaluation

Any lending operation currently are re-evaluating their going concern and the future of their business model. Any financing operation without a stable deposit base is at risk and have a bleak future. That's why the investment bank have disappeared from wall Street. But this change will affect many other operations depending on leverage,like leasing companies, mezzanie funds, commercial real estate reits..etc. One of my holdings NorthStar realty is one of those affected as it is a commercial financing company.

The entire sector of REITs specializing in financing commercial-property transactions are facing headwinds. Companies like NRF, Gramercy, CBRE Realty Finance Inc. and Arbor Realty Trust Inc., have seen their access to capital severely reduced by the credit crunch. They are also suffering from a dearth of property transactions and rising defaults.

The business model of traditional commercial-mortgage REITs -- which act like leveraged bond funds, making money only if the yields on their investments exceed the cost of their borrowings -- has been rendered obsolete by the credit crisis. Early this year, Gramercy bought a REIT that owns real estate to help diversify its business.

from the Wall Street Journal:

The reason: These companies have depended heavily on the ability to sell securities stuffed with the loans they originated, called collateralized debt obligations, or CDOs, in order to lock in financing for a longer period of time to match their mortgage portfolios with long-term maturities.

Today, with the CDO market all but shuttered, there is a lack of long-term debt financing that they can rely on to fund the acquisitions of assets.

"While I expect further loan impairments, the real focus will be on liquidity and any potential violation of their credit facility and bond covenants,"

NorthStar already has diversified away from the mortgage reit model into operating commercial real estate business before the credit crises. NRF has diversified into Net-lease operations through two joint ventures, Wakefield Capital, LLC, owning medical facilities and another venture, LandCap partners, with Goldman Sachs to buy distressed land rom home builders.

They have just reported their earnings and I have to say the report looked really good. Here are some highlights:

• continue to buy back their own CDOs at 50% discount; mark-to-market works on both sides of the balance sheet.
• The have no non performing loans (NPL).
  
• Book value increased to $15 per share from $12 in Q2 2008
• Management owns better than 10% of the company
  and is managing for the long term.
• very good liquidity and cash position.
• reaffirmed their dividends.
  

Despite an excellent report this quarter, management did indicate some
potential problems:

• There are very uncertain loans on their watch list which very easily can become NPL; of especial significance is the WaMu tenant lease which brings over $5 million in revenue per year. JPM after taking over WaMu from the FDC has 90 days from acquisition to decide what to do with the leases.
  
• NRF is accumulating cash and not doing much loan origination, which will impact future earning
• also management said their earnings will be less if LIBOR continues to decrease which is what they expect, again hindering their net income and dividend.
  

I think at this point I will keep my investment in this business as the fundamentals and the reasoning that I bought NRF are still valid. NRF has a favorable chances of surviving this episode of the crises and emerging as a commercial real estate company. Yes the price have dropped significantly, and chances are it may drop further, from my cost basis but I think I will hold this one.

Lehman's Commercial Real Estate

I hope that I will see the planned spin off of Lehman's commercial real estate because I think it will be dirt cheap, everyone will dump it because it is the "bad bank", leaving a very attractive opportunity to buy at low valuation. So let me examine some of the potential holdings. Lehman till now did not specify what will be in the spin off.

REI Global, the Lehman spin off, most likely have a portfolio that is mixed and includes the company’s equity position in the Archstone-Smith Trust apartment portfolio, which it purchased in partnership with Tishman Speyer Properties last year. Tishman Speyer and Lehman Brothers completed a $22 billion leveraged buyout of Archstone Smith a year ago last August.

Off course they overpaid for their buyout at the height of real estate valuation in 2007. At the time, Englewood, CO-based Archstone was one of the largest multifamily REITs with about 86,000 units worldwide. Barron's called the deal a "gigantic gamble" because Lehman and Tishman would be paying more than $1 billion in interest -- more than Archstone's $800 million projected NOI for 2007 -- on the $17 billion borrowed for the deal. based on these figures, they did this transaction at a blended cap rate of about 3.6%, a very high valuation.

One of their mortgage investment is in SunCal Cos. SunCal is a California land developer with 250,000 residential lots and 10 million square feet of commercial properties, the company has a huge development pipeline in California.  Obviously this holding is troubling given the current environment for home builders. Serious questions must be attached to the ability to SunCal to refinance and sell its pipeline. Already SunCal debt has been downgraded to non performing by Moody's in march 2008 and there are several non payment on loans to lenders.

Here is the breakdown of their portfolio by dollar value:

Geographical break down:

• 57% of the holdings are in the Americas,
  
• 26% in Europe, and
  
• 17% in Asia.

Assets class breakdown:

• 58% are debt positions,
  
• 26% are equity positions,
  
• 16% are securities.

Property type breakdown, largest values:

• multifamily properties represent 22%, and
  
• office properties represent 18%.

Bank of America and Lehman

Since yesterday a lot of news reports came out about Bank of America is in talks to buy Lehman Brothers. Lehman Brothers have fallen pretty hard as market confidence eroded its ability to do business. I do not know if all the talk about its liquidity is warranted or not. But it is in a distressed situation and BofA may scoop it up at dirt cheap prices.

I am not particularly fond of investment banks. I actually hate them. I do not think their earnings are as good as commercial banks. Moreover they are not immune to stupid behaviour. I actually hate that BofA is thinking about acquiring them and that will lead me to rethink my ownership of BofA. Here are few quick thoughts that come to mind:

1. Integration and execution risk: BofA just finished acquiring Countrywide and just before that Lassalle bank. Adding another acquisition like this can overwhelm BofA management and lead to distractions and lack of focus therefore letting small things fall and lead to terrible outcomes.
   
2. Culture clash between traditional banking and the bravado of investment banking. Too many times BofA CEO has displayed his contempt to investment banking and now he is acquiring one, albeit a smaller one than more of its competitors. Investment bankers think of themselves as God's children on this earth. How can they coexist with their dominions in the form of commercial bankers especially if the big boss is a commercial banker himself.
   
3. Too many risks in Lehman balance sheet that I can not easily understand and value. BofA is complex as it is adding an investment bank is way too much for me to follow and understand.
   
4. BofA is becoming like Citi bank maybe too big to manage. To be fair Citi is more international and have more insurance business lines and more complicated than the combined BofA and Lehman, but your get the picture.
   

So what could Bank of America do with Lehman Brothers? Some think a lot and can be good complementary addition to BofA's business lines. Here is an analysis from the Wall Street Journal:

A lot, as Lehman’s investment-banking strengths don’t overlap with Banc of America Securities. Lehman targets big companies as clients, while Banc of America has much more of a presence in the so-called middle-market because of its commercial-banking experience with midsize companies. Lehman has a credible presence in Europe, while Banc of America doesn’t.

Broken down by business lines, Banc of America is slightly stronger in fixed-income, where it ranks No. 10 in global debt underwriting compared with No. 13 Lehman. Banc of America is one of the top banks in underwriting high-yield debt issuance and leveraged lending, where Lehman barely has firepower.

Lehman Brothers is stronger in equities underwriting, where it ranks No. 9 compared to Banc of America’s No. 14 this year, according to Dealogic.

In individual investment-banking groups, each has its own strengths: Lehman is powerful in advising natural resources, oil-and-gas companies and retailers, while Banc of America is stronger in health care and real estate. And Banc of America has just built a new building in midtown Manhattan, just blocks from Lehman’s current headquarters.

Then there is question of prime brokerage, a business that provides support services to hedge funds. Banc of America Securities recently sold its prime brokerage to BNP Paribas, and in buying Lehman, it would be getting back into that business, just as hedge funds are using less debt and spreading their money thinly across multiple prime brokers.

I hope that this transaction do not go through. If it does BofA will be a speculative holding in my portfolio waiting for a break even price to get out, as I am down some 17% so far on it. I may have to take that loss and move on and add the selling proceeds to US Bank corp, another holding of mine.

Lehhman Commercial Real Estate

Here is a CNBC video clip that echos my thought from my earlier post today. see it here

Lehman brother to Split

Lehman Brother will spin off its commercial real estate into a separate company according to their conference call. Depending on the portfolio and the leverage, which they said will be "appropriate" for the economic cycle. I translate that into conservative leverage. This can a good opportunity to own some commercial real estate at steep discount.

Look, the whole crises with Lehman revolves around liquidity and not about the quality of the its assets. Therefore if those assets go on sale it will a great investment opportunity. I can't wait to see the registration statement for the spin off and the details of the assets. Moreover, the whole crises, if you call it that, in commercial real estate is one of financing and not fundamentals of oversupply and rent growth, retail in some markets is an exception.

Lehman is  expected to complete the spin off in Q1 09.

Commercial Real Estate: The lost Cycle

If you read some of my posts and tracked some of my investments you will notice that I am betting on Commercial Real Estate. Commercial real estate (CRE), I mainly focus on retail and office spaces, cycle has been lost amid the residential housing crash. In this post I want to look more closely to the CRE sector and outline my investment thesis that will assist me in picking and assessing investment opportunities.

Along with general economic conditions, valuations in commercial real estate are driven by the following factors:

1. Capital availability: Real estate is a capital-intensive industry, and its health rises and falls with capital availability. Capital, relatively cheap, fuels investors demand for CRE projects in the hope of earning future cash flows.
2. Supply: Boom times typically engender oversupply of product.
3. Interest rates and the economy: The lone head wind for commercial real estate is higher interest rates and their potentially negative effect on economic growth.

Actually the factors move in cycle and it goes something like this:

1. Tenant's demand in good economic times for CRE will drive rent prices up making yields very attractive, as a result CRE prices start to go up.
2. builders start increasing their investment in new developments therefore flooding the market with more supply that demand can absorb causing rent prices to start dropping due to competition over tenants. Please note that this takes few years as new supply do not materialize suddenly as projects take few years to complete.
3. CRE prices start to decline as a result of the new supply.
4. Lenders panic and put the breaks on loan refinancing and originations as their collateral is being devalued and realize they are heavily exposed to commercial lending.
5. Developers can't get new financing to finish their projects or refinance existing properties so they default causing banks to take title and liquidate their holding causing more decline in CRE prices.
6. Recovery begins when excess inventory is cleared and rents start to stabilize.

The previous steps are present in almost every real estate boom and bust. But the universal truth in every CRE bust is overbuilding. Then it is followed by system deleveraging of some sort. Currently, residential overbuilding has caused severe price drops followed by a liquidity crises as banks try to clean their balance sheets from bad loans and defaults as result of overzealous lending.

The slow economic environment, the disruption in capital markets and the shutdown of CMBS market will no doubt weight on CRE prices, no questions about it, prices have to come down. Owners have to refinance at some point and when they can't they have to sell at any price to allow them to repay their loans. However will CRE go by the same way as housing and suffer a collapse in pricing? That question can be answered by finding out: if developers overbuild in this CRE cycle. Answering this question have many implications to banking write offs and the severity of CRE price decline.

In the late 80s and early 90s CRE has endured a similar fate to what housing is going through right now. You can argue it was exactly the same but the current crises is much more severe due to the large size of residential mortgages and housing construction compared to commercial lending and construction.

Positives

• The amount of investment in CRE the current cycle is mundane compared to the late 80s and early 90s as percentage of GDP. That suggest that the current cycle of CRE did not terribly overbuild to create excess supply that could lead to a bubble like environment, however still since 2003 non residential investment has picked up a bit, see chart 1 from Wall Street Journal.
• Most of the construction investment happened in secondary markets, take the example of office construction as in the graph 2, courtesy of CB Richard Ellis research.
• Construction prices have skyrocketed due to natural disasters and rising commodity prices, which has tempered new building in all property types. That lack of new supply increases rental pricing power and occupancy levels in existing properties. New developments will incur higher costs so they have to charge higher rents to earn good returns giving an advantage for existing buildings to charge less rent. That dynamic will limit new developments and construction a bullish sign for CRE valuation.
• Most recent construction happened in suburban locations or B and C locations. Downtown real estate saw little change in construction levels over the past few years as you can see in chart labeled office construction. Further evidence is the available sublease space is also low compared to previous cycles as seen in chart labeled available sublease space. The limited construction and further decline in construction in the downtown office market will lead to higher rent growth once the US comes out of this rescission and employment starts to grow again.
• Real estate funds are flushed with cash and new ones are being formed to take advantage of the dislocation in capital markets

Negatives

• Retail space will face tougher outlook than office due to retailers bankruptcies and slow down in consumer spending. Space vacancy is highest in retail space in a decade. Take for example some of the recent events for retailers:Two retailers on the brink of collapse with strong potential to announce major store closings over the next six months include Steve & Barry's, which operates 276 stores, and Circuit City, which operates 696 U.S. stores. Add to this the likelihood that Linens 'N Things will liquidate the remainder of its store fleet (382 stores, as it already announced 120 closings in May and another 87 this week) and Whitehall Jewelers, which just filed bankruptcy, will liquidate its 373 stores, and there is already another 1,721 possible closing announcements over the next six months. Foot Locker is closing 140 stores; Wilson's Leather is closing 160; Ann Taylor, 117; and jeweler Zales has closed 105.
• For some chains, times are even more desperate, and the drumbeat of retail bankruptcies grows louder by the day. So far this year, 15 retailers with assets of $100 million or more have filed for Chapter 11 bankruptcy, up from seven for all of 2007, according to Bankruptcydata.com, which tracks such filings.
• Property & Portfolio Research expects the final tally of store closings for the year to climb to more than 6,000, compared with 4,600 closings in 2007. As of mid-August, Boston-based PPR reports 5,300 closings. Of the store closings tracked by PPR, 46% are located in malls and about 43% in strip centers, with the remaining stores tied to big-box retailers. The current retail vacancy rate nationally is 11.8%, according to PPR. The firm forecasts the vacancy rate to rise to approximately 13% by the end of 2008 and 14% by late 2009. Apparel stores accounted for about 35% of the 2,831 store closings tracked by the International Council of Shopping Centers (ICSC) in the first half of 2008. About 6.5% of the store closings through the first half of 2008 tracked by the retail industry trade group were in the home furniture and furnishings niche, one that moves in tandem with the housing market. However, this is an improvement considering that this niche accounted for more than 14% of store closings in the first half of 2007, and about 34% of the closings in the second half of 2007, according to ICSC.
• Lack of liquidity: CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have available property will be able to get refinancing.

Conclusion and CRE investment thesis
One of the good things about the recent economy is that in most sectors--excluding the residential sectors--there was relatively little overbuilding. High oil prices, high commodity prices and fierce competition for construction equipment and material in other parts of the world--China, India, and the Middle East--tempered the market's tendency to overbuild and will make new space less competitive. The lack of over-supply in the US commercial real estate market will help to support and speed the recovery in the market. I will focus on companies with portfolios of downtown office space like Brookfiled Properties and Boston Properties as they own unique assets with high barrier to entry. The slowdown in lending and capital market activities has put the breaks on new developments making new supply in the future virtually non existent therefore allowing existing office space to command higher rent due to limited supply in the future. I will avoid companies with large development business or pipeline as they will get chocked in this current environment and their prospect of earning good return is outweighed by risks involved. I will avoid retail properties due to significant risks to their ability to increase cash flows. Supply in retail properties is abundant at the moment due to string of bankruptcies. But in general these vacancies are a function of economic slowdown and the same thesis for office space applies to retail. unique assets will command a premium due to higher replacement cost and the drying up of financing for new developments.

_________________________________________
Sources:

• COstar
• http://nreionline.com/property/retail/challenging_months_shopping_center_owners_0812/
• CB Richad Ellis Research
• Jones Lasalle Research
• http://online.wsj.com/article/SB120511166583823441.html?mod=rss_whats_news_us
• http://www.businessweek.com/print/bwdaily/dnflash/content/aug2008/db20080811_680564.htm

Value Idea: NorthStar Realty- part 2- Risks

Part 1 can be found here.

Investing in what is called mortgage REIT is very risky and not for the faint of heart. Mortgage REITS market caps can be cut in half within few hours, and some actually have evaporated into bankruptcy heaven, hell is more like it. So it is important to list my risks and look down rather than up on this one. Actually if you read their quarterly or annual SEC filings you will be reading 3-4 times the number of pages of any other company. So here goes:

• Liquidity: NRF has a good liquidity profile with some $296 million in cash and liquid securities.
  
• Exposure to retail: Retail commercial real estate might be a sour spot and in a weaker position compared to other CRE properties and run the risk to suffer more defaults and losses. NRF has 8% mundane exposure to this retail properties.
• Leverage: conservative leverage running about 3:1 compared to others with leverage that reaches up to 30:1.
• origination discipline: management is very conservative in its risk management program. They avoided all of the residential fiasco by not buying intosubprime . They also originate their own loans rather than buying on the market so their have fist hand due diligence on borrowers and most importantly in most cases they have recourse on borrowers to recover their investment, if the loans go south.
• no delinquencies in their portfolio so far and do not expect significant delinquencies in their CRE asset backed securities (CMBS) as most of their portfolio in CMBS have been accumulated prior to 2004 avoiding aggressive lending practices in the peak of the credit bubble from 2005 to mid 2007, see distribution of theirCMBS portfolio by vintage year.
• with respect to risks associated with their CMBS portfolio: A 15% drop in property values will do relatively little to adversely impact the credit ratings of older vintage U.S.CMBS , even those tranches that are deemed impaired, according to Fitch Ratings in a new report titled '98% of Seasoned Deals Pass Stress Tests'. Other findings from the report:
  
• Fitch stress tested its rated U.S. CMBS portfolio with significant exposure to near term maturities in order to address concerns about the stability of ratings. Tests were performed on loans maturing through 2012 and the results were evaluated on each transaction tested. Fitch concluded that these older vintages inCMBS were well-insulated in the event of a sizable drop (15%) in property value. Of the 1,381 total classes stress tested, only 138 were considered 'impaired', with only 20 of those tranches at the investment grade level. By class balance, 97.8% were considered not impaired, or $74.1 billion of the $75.8 billion tested. Classes that were determined to be impaired either incurred a hypothetical loss in the stress scenario, or the resulting credit enhancement deemed too low to support the current rating.
• How bad can it get for commercial mortgage-backed securities in the event of a recession in the U.S.? A stress test on commercial mortgage-backed securities (CMBS) in 675 CMBS bonds, finds that CMBS securities rated BB have as high as a 63% chance of downgrade in a recession scenario, according to a recent Fitch study commissioned by industry trade group, Commercial Mortgage Securities Association, so you may want take that conclusion carefully. Moving up the investment spectrum, the odds against downgrading improve. Bonds rated BBB- have only a 47% chance of downgrade, while those rated BBB face a 31% chance of downgrade. AA-rated bonds face a low 2% chance of downgrade and A-rated bonds face a 6% risk. AAA-rated bonds in the stress test showed a 2% risk of being downgraded.
• Expected losses could reach as high as 46% in the case of BB-rated bonds and as low as 1% for A-rated bonds. In the case of BBB- bonds, expected loss is more than 17%, and investors in BBB bonds could see more than a 9% loss. HoweverNRF portfolio is investment grade only and do not have any of BBB- assets.
• Match funding: 91% of NRF capitalization comes from long term debt the balance is from short-term credit facilities provided by JP Morgan
• CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have a viable property will be able to get refinancing.
• No exposure to residential or sub prime and thus they are in better shape and their portfolio did not take a big hit.
• Retail properties exposure: Retail CRE is one of the most problematic segments in CRE with many retailers under pressure due to consumer cut back on spending. NRF exposure to this sector is a mundane 8%
• interest rate risk: NRF earns a spread between borrowing and lending rates so if borrowing and lending rates converge earnings will vanish and the company will be under pressure.
  

continued credit market instability, poor visibility on commercial real estate valuations, and a continued lack of liquidity in the CRE market are all uncertainties surrounding this type of business but I will buy those risk in the face of these uncertainties.

The book value is $12.5 which give me a 43% discount from its recent trading price.

This is a position to capitalize on irrational fear of all thing real estate. According to my thesis CRE have been thrown out with the bath water.

_____________________________________________________

Sources:

http://www.costar.com/News/Article.aspx?id=1E13D71105CE6E81353B2EA18B4FD2B6&ref=1&src=rss

http://www.pionline.com/apps/pbcs.dll/article?AID=/20080804/PRINTSUB/261816697/1013/REALESTATE

http://10qdetective.blogspot.com/2008/01/stop-following-sheep-now-time-to.html

http://www.pionline.com/apps/pbcs.dll/article?AID=/20080804/PRINTSUB/560975272/1031/rss01&rssfeed=rss01

http://www.reuters.com/article/ousiv/idUSN0843417620080810?sp=true
http://www.reitwrecks.com/2008/06/cmbs-prices-reflect-irrational-fears.html
http://nreionline.com/finance/investors/real_estate_catch_mezzanine_lending/
NorthStar realty presentations and SEC filings

CB Richard Ellis various research

Fitch research

Value Idea: NorthStar Realty

I have talked a lot about Commercial Real Estate (CRE) debt market in the past, see here, here, and here , and how pricing really do not reflect its economic reality. Mainstream media superficial analysis and reporting and fear from a repeat of the housing collapse have put downward pressure on all things real estate and CRE was not spared. I have also noted that CMBS debt have took a steep hair cut along with residential debt and now their pricing are attractive given their risk/ reward profile, see chart for spread over 10 year Treasuries. To be clear, I do not think this distress debt thesis will yield as a good of a result, if any, as in the previous crashes of CRE in early 1990s and 2000 downturn. There are just too many funds chasing these securities and crowding the market, keeping prices up. But still the returns can be worth while. I want to take advantage of this opportunity and place my bet, but what eluded me is how?

Then, I found NorthStar Realty Finance (NRF), the idea came thanks to reitwrecks.com. NRF is ...

... an internally managed real estate finance company that focuses primarily on
originating and acquiring commercial real estate debt, commercial real estate
securities and net lease properties. The Company conducts its operations so as
to qualify as a real estate investment trust (REIT) for federal income tax
purposes.

I bought into NRF at $8.6 on August 11 and it comes with a dividend yield of 16%, lets hope that I can see some of this yield this year!

Investment rationale:

1. CRE Economics are OK: CMBS underlying market have relatively good fundamentals but they are priced for disaster defaults, which I do not think will happen. I have made this case before in various posts.
2. Growth potential: I see several trends and reasons for increased business pipeline for NRF:

• The tight credit environment offer opportunity to NRF to extend and originate loans and/ or buy discounted assets and debt. The CMBS market along with structured debt have evaporated overnight with the credit crises. It may be resurrected in the future but it won't be in the near term. Banks and traditional lenders are grasping for capital and as a result have tightened lending so much. However, there has to be a credit provider alternative for businesses and CRE and even individuals. There has to be some entity to fill the void for the market to function smoothly, albeit maybe at a higher interest rates, equity like rates of return maybe. I think private equity and companies like NRF will fill that void. It won't be cheap but I think they will price risk better than the banks did over the last 5 years. I think the growth potential here for NRF is absolutely terrific.
• As Banks try to deleverge their balance sheets by selling loan portfolios. NRF will buy at steep discounts such portfolios and can earn high return on equity invested.
• Another area of growth opened for NRF is sale-and-leaseback transactions, where corporations that own their offices sell them to raise capital and then lease them back from the new owners. Banks are engaging in these transaction at feverish pace; Citi bank, BofA, and many others are doing these transactions more and more. NRF has already done a number of them to Fortune 1000 corporations and will do more as corporate America tries to raise capital.
• Mezzanine loans to owners is another growth area for NRF. Those loans provide equity like returns to originators and the dislocation in the credit markets makes the returns more attractive. Private equity outfits like KKR and Blackstone have been raising funds to take advantage of this segment, see story here. Distressed debt funds raised 38% more capital globally, raking in a total $33 billion in the first half of this year according to Private Equity Intelligence Ltd. The global pool of mezzanine capital doubled to $20 billion. The top three U.S. funds raised so far this year are: the $15 billion Warburg Pincus Private Equity X; Goldman Sachs Private Equity Group's $13 billion GS Mezzanine Partners V; and Oaktree Capital Management's $10.9 billion distressed vehicle, OCM Opportunities Fund VIIB. All this capital raising validate the thesis for NRF business model right now.
• Liquidity is king: NRF has about $295 M in cash to deploy and in a time where liquidity is in short supply, those funds will earn excess returns. As I said above they can deploy these funds into areas of opportunities with high return on equity.
• Experienced Management: good quality and accomplished management in the real estate and investment world. Moreover they own about 10% of outstanding shares and have been buying recently, always a good sign. NRF is internally managed that means that no asset manager is hired to mange the fund and carry the mandate. It is set up as a corporation that have employees and they make the investment decision rather an externally hired asset manager and in this case they have skin in the game through their ownership.

In the next post i will detail risks and valuation.

new position added

I have purchase CB Richard Ellis (CBG) two days ago at $13.50 per share. I will post a complete write up on this opportunity, but highlight for my purchase:

1. Premier real estate service company in the world.
2. Commercial real estate fundamentals are deteriorating but will crash as many expect and therefore many real estate operation prices are selling at steep discount to net asset value.
3. the outsourcing segment, which have recurring revenue and is not affected by occupancy as maintenance has to performed on a building if it is empty or not, valuation alone equals to market cap of CBG and you get other segments for free.
4. The company has an international network of services in growing markets.
5. Top skilled management that can navigate difficult market conditions.
6. Commercial real estate prices do not affect their results as much as lack of transactions. Transactions over the last 6 months have been almost non existent but that is a temporary event that can reverse quickly.

The valuation of CBG has gotten really attractive after their earnings release, which has declined by some 80%. The company represent good value at these levels for the long term holding.

Macklowe Strikes Deal to Sell GM Building, Three Other Towers - WSJ.com

Macklowe Strikes Deal to Sell GM Building, Three Other Towers - WSJ.com

So Mr. Macklowe saga concludes with the sale of the GM building to a group of investors. He lost significant chunk of his real estate empire thank to the credit crunch. Actually it was his doing by borrowing short and investing in long term assets. It is the worst funding strategy for any real estate transaction and its risks have been magnified by the credit crises.

The deal for the GM building has many implications for the commercial real estate sector:

• It is not the same as residential real estate. The dire scenarios will not materialize for commercial real estate.
• Sovereign wealth funds are ready to make deals and buy trophy buildings which should give commercial real estate some support.
• GM building valuation under duress fetched a record of $2.9 Billion and a record per square ft sale price of $1450.
• It validated my earlier posts of the value in high growth urban office and retail real estate. Most commercial real estate indexes have been stating that commercial real estate is declining but these figures are based on thin volume and does not reflect the economics of this market. so may be with this deal some the deal flow will return and we get a clearer picture of the true market values.

The transaction comes at a time where sellers are holding up selling due to low bids on their assets. The transaction might be a catalyst for buyers to up their bids a bit to entice sellers to do deals.

FirstService: Commercial Real Estate Value Idea

Real Estate companies have been under stress due to the burst of the housing bubble and deleveraging occurring in the economic system. All types of real estate firms from REITS, services companies and financiers have declined significantly from mid last year into this year.

I have been wading through the sector to find good buys and have review some in previous postings. Today I made the purchase of FirstService Corp; I bought an entry position in the company that I am hoping to add more in the future as i think it will come down in price somewhat in the short term.

FirstService Corp. is:

.... a leader in the rapidly growing property services sector, providing services in the following four areas: commercial real estate; residential property management; integrated security and property improvement services. Industry-leading service platforms include: Colliers International, the third largest global player in commercial real estate; FirstManagement Partners, the largest manager of residential properties in North America; FirstService Security, the fifth largest integrated security company in North America; and The Franchise Company, the second largest franchisor of residential and commercial property services in North America.

Investment Rationale:

• Premier real estate company with international exposure.
• leading market share in residential property management.
• full service platform for commercial real estate
• Asset light operating firm
• variable cost: about 60-70 of its cost is variable, they will do well when real estate boom and costs will come down in bust times.
• recurring revenue stream from property management
• Strong management team
• Strong ownership structure

Valuation
I beg the value to be in the range of $31 on low end and $50 for the high end. The company is asset light and most of the valuation is based on the brand name they have and future earning prospect. I will have a more detailed writeup soon.

Broofkfield Properties: Value Idea

Overview

Brookfield Properties Corporation (BPO) is a commercial real estate company. The Company operates in two principal business segments: the ownership, development and management of commercial office properties in select cities in North America, and the development of residential land. As of December 31, 2007, the Company’s commercial property portfolio consisted of interests in 109 properties totaling 73 million square feet, including 10 million square feet of parking. As of December 31, 2007, its development/redevelopment portfolio comprised interests in 16 sites totaling 18 million square feet. The Company’s primary markets are the financial, energy and government center cities of New York, Boston, Washington, D.C., Houston, Los Angeles, Toronto, Calgary and Ottawa.

Office Real Estate Macro Factors Affecting Supply and Demand:

• Foreign buyers and sovereign wealth funds are looking to focus on buying trophy office properties in major cities like Boston, new York, Chicago...etc. This will put a floor on potential steep price decline.
• Although demand for downtown office space is expected to decline slightly over the next one-year horizon, Moody's said that supply has also slowed to barely a trickle-down to 0.6%, its lowest level since 2005. As a result, the relatively small supply-demand imbalance should not undermine market stability too profoundly.
• Fundamentals are deteriorating as vacancy rates are increasing and due to low absorption rates there is downward pressure on asking rents in the short term.
• Immigration towards "mega cities", see my post earlier here. The trend of immigration towards mega cities will create demand for office space and real estate in general. The table to the side displays the percentage rent growth year over year in major cities. The demand for limited down town office space will grow as long as the trend is intact.
• Supply will be limited in the future. The lending issues will slow development down dramatically, and it already has nationally. Nationally it has greatly slowed down the pace of new development. Capital will not be as readily available for new projects unless there are just very compelling reasons to do so — unique locations, tremendous pre-leasing to creditworthy tenants. Good projects will get done. Marginal projects won't be offered capital to develop them.
• The boom in material and base metal prices will undermine new projects as costs are becoming more prohibitive and decreasing potential returns. This will lead to decrease in new supply in the future increasing the value of current properties.
  

BPO Micro Factors Affecting Revenue Growth:

• BPO owns premier class A office buildings in major metropolitan cities like New York, Los Angles, among others highly dense populated cities. Below is a listing of their cities and owned space.
• Most of these properties are downtown properties. Any downtown property in a major city has a very sustainable competitive advantage: high barrier to entry. with down town properties there exist a high barrier to entry as New building supply in some of these markets is not easy to come by.
• Rent charged to BPO's tenants is below market asking rent. BPO have a chance to grow its rent by raising new leases with tenants to market asking rent. The growth potential from new leases can contribute to BPO's FFO growth.
  

City	Total Area (000,000's Sq. Ft.)	% of total
New York Downtown	13.2	18%
New York Midtown	6.3	8.6%
Boston	2.2	3%
Washington, D.C.	6.5	8.8%
Houston	7.9	10.7%
Los Angeles	10.7	14.6%
Toronto	10.3	14%
Calgary	6.7	9%
Ottawa	2.8	3.8%
Denver	1.8	2.4%
Minneapolis	3.0	4%
Other	1.8	2.4%
Total	73.2

Risks and Uncertainties:

A broad recovery in property share prices is likely to hinge on how quickly and completely the global economy works through the liquidity and credit crises that escalated in 2007. U.S. real estate securities were trading at an 18% discount to their underlying net asset value as of December 31, 2007, compared with a premium of 13% at the end of 2006, and compared with a historical average premium of 5%. The size of this discount suggests that the market is expecting at least a mild U.S. recession and a meaningful decline in property values. However, the strength in commercial real estate fundamentals and cash flows, I do not think a meaningful decline in property values will occur.

• Economic Risks: There is a high probability that slower economy would impact the intrinsic value of BPO. As the economy slows down and money centre banks layoffs accelerate due to the credit crunch, office space demand will slow. In general there is a small probability that commercial real estate will decline by 15-20%. However the office market in major city centres will face a smaller decline due to high barriers to entry. I estimate 0-5% chance of such decline for cities like New York, Toronto, Houston and LA. If we have a severe recession in the U.S., it will put stress on the system. Right now I am not seeing a multitude of tenant bankruptcies, but there are profits decline. If you have a rash of tenant bankruptcies, it will slow down demand for office space.
• Income Risk: With a high probability of slowing demand to one of BPO's biggest markets, New York, due to lay offs in the financial industry, BPO can't realize the rent growth or sustain high level occupancy. BPO will be very hard pressed to raise rates in such an environment. It won't see rent declines but growth in rental revenues will be limited. The Canadian office market may offset some of this risk as the Canadian office vacancy rates at record low levels.
• Financing Uncertainty: with the credit issues still hangs over the banking sector, financing or refinancing any property is difficult. However, BPO is a premier property company, it will get any financing done through insurance companies, commercial banks or pension fund companies as they are still large player in commercial financing. Having said that I think the financing will be at a higher rate absent the competition from the CMBS market. However, in this uncertain credit market it will present financing risks particular to BPO in several ways:

1. Higher financing costs. Most fixed financing, which what most real estate operators use, has higher rates due the tightness of lending.
2. Miss match of funding. With higher fixed rates BPO have opted to use the variable and short term debt packages, which leads to miss match between its asset and liability. Miss match funding is very risky for a real estate owner, which can lead to fire sale if BPO could not refinance in the future. The episode of Macklowe unravelling properties due to short term financing is a perfect example of funding miss match risks. Macklowe had to liquidate the premier and the crown jewel of his properties in a hurry to raise funds as he failed to refinance a one year loan to buyout seven building from Blackstone deal with Sam Zell.
3. High leverage of BPO. BPO has a higher leverage ratio compared to other US and Canadian reits, management says it is not a problem, but I beg to differ. BPO employs 61% Long term debt to Enterprise value, while other US reits uses just under 50% with the quality names using under 45%. Since values are falling in the short term, the last thing you want is too much debt. With the lack of financing in the market, this means we are left with a select few of longer-term investors—those with significant equity to invest as part of long-term programs. This shift will definitely start to dictate lower pricing if BPO needs to sell something and in general will reduce the intrinsic value of the company.
4. Refinancing risk. BPO has 11% of its commercial debt due with 12 months. That is a large chunk to be refinanced in this environment. Commercial banks in Q1 of 2008 have reduced their lending activities by 26% year over year ( figure from Reuters Loan Pricing Corp). If the loans are refinanced, it is going to be at a higher rates that will eat into their FFO figures. Moreover they have 8.8% of their long term debt from Commercial Mortgage Backed Securities debt that they have to refinance at various times which poses a significant refinancing risk. The CMBS market has all but shut down for any new securitzation. BPO has to find an alternate funding source from a commercial bank or an insurance company.

Given these risk and the potential for a company like BPO and Commercial real estate in general, there are two possible extreme scenarios in the intermediate future, and many combination in between, as follows:

		Expected Return
Worst case:	1. deflating asset prices due to continuation and deepening of the credit issues, which can put a downward pressure on commercial real estate prices in the short term as well as increase financing costs. 2. economic activity takes a steep turn for the worse 3. BPO refinancing risk is realized.	decline of 15-20% of NAV
Best case:	1. a recovery in financial industry and 2. a resolution of the credit crises, which means a substantial reduction in the risk profile explained above. This scenario will likely play out in the span of 18-24 months.	increase in 5-10% of NAV

Valuation:

The stock is not cheap. I figure it is fairly valued at $20 a share; its Net Asset Value (NAV) ranges between $21-29 per share. I have determined its NAV in two ways:

1. Using Cap rates for recent quarter and applying it to BPO's recent Net Operating Income (NOI).
2. computing average recent sales per sqr ft for comparable properties in BPO's markets and applying it to its owned space.

Please note that sales prices in Q1 2008 are scarce as not many transaction have been done due to tight credit and financing. That's will affect most of the valuation points that I gathered whether it is CAP rates or market sale price per sqr ft. Therefore I will apply a discount of 3% to all valuation computed using the decline in the S&P/GRA Commercial Real Estate Index from its peak in 2007 as a measure of decline in BPO properties.

Cap Rate Approach:

The current prevailing national blended cap rate for office real estate is 6.5%, according to CBRE. Using this cap rate the market value of BPO properties is $21 Billion, 33% higher than its book value of $15.8 Billion. I am confident that BPO's specific properties will yield much tighter CAP rate than a blended average. Their properties are all class A buildings in the heart of mega cities where CAP rate can reach 4-5% even in slow economic times as the one we are in. Here is a range of probable real estate values:

CAP Rate	Properties Value	Premium to BV
7%	$ 18 Billion	14%
6.5%	$ 21 Billion	33%
5.5%	$ 22.9 Billion	45%

Using recent Sale prices, I got the following prices (using LoopNet DB):

	NET OWNED	High MKT	Low Mkt	High end Value	Low end Value
Market	INTEREST (000)	Price per Sq FT	Price per Sq FT	in 000s	in 000s
Boston	2,150	520	700	1,505,000	1,118,000
Calgary	2,899	200	250	724,750	579,800
Denver	1,795	300	400	718,000	538,500
Edmonton	157	200	250	39,250	31,400
Houston	3,744	200	300	1,123,200	748,800
Los Angeles	4,721	200	300	1,416,300	944,200
Minneapolis	3,008	100	200	601,600	300,800
New York	13,210	1,000	1,100	14,531,000	13,210,000
Niagara Falls	47	100	100	4,700	4,700
Other	73	100	100	7,300	7,300
Ottawa	618	382	400	247,200	236,076
Toronto	5,770	364	400	2,308,000	2,100,280
Vancouver	759	200	250	189,750	151,800
Washington, D.C.	4,093	300	500	2,046,500	1,227,900
Total				25,462,550	21,199,556
Discounted Value				24,698,673	20,563,569

BPO's properties seem to range from a low end of $20.5 to a high of $24.5 Billion. Both figures represent a NAV premium to the market price of BPO between 2%-39% (adjusting for some balance sheet accounts).

Conclusion:

With several risks that outweigh potential rewards or upside in BPO, I will stay out of this one for the time being. I will start buying at or below $17.5, which the stock have touched in recent weeks, but I was in the midst of my analysis then. I think at that level I have enough of a discount to justify taking on mainly financing risks associated with BPO. I will also be a buyer at $20 per share, if the credit issues are resolved and the lending environment returned to normal, or showed signs of returning to normal as it is showing now.