Thursday, November 22, 2007

Crisis Looming at Maguire Properties?

Continuing my series on looking for stocks likely to suffer from macro themes, I've recently been doing some work on REITs. I have been short RWR since early in 2007, a play that has finally started to pay off, but was hesitant to choose individual companies due to my lack of ability to distinguish one REIT from another. As I write this now, I still am far from an expert, but believe I have a better understanding of the underlying REIT dynamics due to work I've done educating myself these last couple months, and am confident enough that I plan to begin to make some specific REIT bets. With that disclaimer out of the way, lets dig in.

In my search for potential shorts, I have focused on two main qualities:

1) High leverage (Debt/Equity)
2) Exposure to local economies most likely to be hard hit due to recent macro issues (e.g. Florida, Southern California)

REIT companies with exposure to hard hit aspects of the economy are likely to struggle with lower rents, high vacancy rates, and other issues that should reduce their NOI (Net operating Income). The more a REIT is leveraged, the more macro issues are unlikely to affect their bottom line and the quality of their balance sheet. In some cases, such as Maguire (MPG), it seems as though these issues could very well affect their solvency.

Maguire Properties Overview
Maguire Properties is a highly-levered commercial real estate REIT with properties concentrated in Southern California. The general thesis here is that it is looking increasingly likely that MPG will either be forced to cut their dividend, to continue to liquidate existing properties, issue a dilutitive equity offering (if they can get anyone to buy it), or sell the company. The company needs a friendly debt market to continue operating as it is, paying a dividend and continuing developement of its projects. I believe the most likely outcome is sale of the company, either by choice if they do it soon, or by mandate if they don't. At these prices, I think the downside of a short is limited at NAV, and the upside could be 30-80% depending on how quickly and how much the MPG's assets erode in value.

MPG has some serious balance sheet issues. Let's take an abbreviated look at some key numbers for MPG (numbers in million):
Market Cap: $1,212
Net Debt: $4,817
Enterprise Value: $6,029

Total Equity (including Depreciation): $6,353
Total Debt: $5,492
Debt/Equity: 86%

The big issue here--outside of the enormous interest payments and consistent reliance on borrowings to fund the dividend and operations--is that a relatively small impairment of the equity (in this case, about 14% at book) would entirely wipe out the equity.

The above is a proxy value for the equity based at book (cost). But in reality the value of the equity is always shifting. Here's where things get interesting--analysts are mostly sour on the stock, due to macro issues, poor operating performance, and leverage. Most analysts, however, still see downside protection in the NAV, which most peg at ~$30/share. Management rejected an offer in late 2006 at between $42-44/share, and reportedly tried to engineer a buyout of the company at $60. Though there are several ways to value NAV, the most accepted analysis is the Net Operating Income of the properties divided by the cap rate, which is the discount rate applied to the operating income to get a total value of the cash flows. Then you subtract the debt, and divide by the total outstanding shares to get the NAV/share of the equity. Let's take a look at historical cap rates:

Keep in mind that lower cap rates mean a higher implied NAV value. Cap rates were recently at historical lows, due to higher expectations for underlying asset appreciation, lower cost of borrowing, and the availability of more leverage, all of which made the actual performance of the property as an income producing asset relatively less important. These conditions, which existed as recently as a few weeks ago, are gone, and it does not look like they are coming back. In an increasing cap rate environment, that equity cushion is easily wiped out. What happens if cap rates rise to anything approaching historical levels? Below is an analysis of what happens to NAV when you change the cap rate assumptions (assuming NOI of $324M & value of other assets of $1,602M):
Cap Rate NAV/share
5% $44.54
5.25% $38.89
5.50% $33.75
5.75% $29.06
6.00% $24.76
6.25% $20.81
6.50% $17.15
6.75% $13.77
7.00% $10.63
7.25% $7.71
7.50% $4.98
7.75% $2.43
8.00% $0.04

At a cap rate of about 8% (well within historical norms, especially in tough real estate markets), the equity gets wiped out. Perhaps noticing these trends, several activist investors have recently gotten involved to try to force a sale of the company while cap rates are still somewhat favorable. It remains to be seen to what degree they will be successful, and what cap rate they can negotiate on a transaction. With the uncertainty in the market right now, California's poor economic outlook, and MPG's poor capital position, I would peg the odds of a deal as relatively small.

I value the upside potential in a short by taking a look at four scenarios, which basically involved valuing the company at 4 different cap rates and assuming an eventual sale of the company @ NAV.

Scenario Activist successful Forced Sale Forced Sale Forced Sale
Probability 20% 30% 30% 20%
Cap Rate 5.75% 6.5% 7.0% 8.0%
NAV @ sale $29.06 $17.15 $10.63 $0.04
Dividends 0 $1.60 $2.40 $3.20
Total Return $29.06 $18.75 $13.03 $3.24
Current Price $25.68 $25.68 $25.68 $25.68
Return -13% 27% 49% 87%
Prob Weighted 5.81 5.63 3.91 0.65

Probability Weighted Return: 38%

With minimal downside risk and strong potential upside, I think the risk/reward here looks rather favorable. Catalysts include increasing cap rates, commercial real estate turmoil, increasing credit spreads and risk aversion, dividend suspension, and decreasing occupancy rates and thus NOI.

Note: Author is not currently short MPG, but likely will be soon. Not a recommendation to buy or sell shares. Numbers herein are accurate to the best of my abilities, but should be double checked. Do you own DD.


Yaser Anwar said...

Great article as usual.

Just to clarify: "With minimal downside risk and strong potential upside, I think the risk/reward here looks rather favorable." You mean risk/reward of going short right? Tx

Boniks said...

Thank you for posting your research--I found it valuable as we look at similar themes at our fund.

One quick question--what is a good source to track occupation rates and other commercial REIT related data?

Thanks again--CF Lemos

Research Intensive Investing said...

To answer your questions:

Yaser: Thanks again. Yes, I meant the risk reward in going short. 20ish% downside and 30-100% upside looks good to me.

Boniks: I believe CSGP is the gold-standard in terms of commercial real estate research, but I haven't seen their data (I only know this because I am short the company). I pulled most of my information from analyst reports. NCREIF appears to also have some great data (that's where the chart came from), but they require a subscription. Hope this helps.

Research Intensive Investing said...


In fact, I took another look at the NCREIF wesbite, and on their homepage you can see historical vacancy data:

Rates jumped as high as 12-13% in the 90' recession. I don't account for decreases in NOI in the analysis. If I did, then the picture becomes even more gloomy.

Another thing worth noting is that this data is probably most useful regionally. California's economy is going down the tubes, and its likely that the occupancy/cap rate situation there could be much more severe than in other markets.

Wesley R. Gray said...

you nailed this one. Thanks again for the great short idea.