A Publication of Paramount Capital Corporation. Strategy and Insight for the Commercial Real Estate Industry

Transcription

1 Volume IV Issue 2 A Publication of Paramount Capital Corporation Mar 15, 2012 Strategy and Insight for the Commercial Real Estate Industry A DISCUSSION OF GRUBB & ELLIS, REAL ESTATE RISK, US DEBT AND REIT FOCUS ON DIGITAL REALTY TRUST, INC. For this issue of VOM, we will discuss the demise of Grubb & Ellis, the venerable real estate brokerage firm, review risks inherent in CRE, review the February budget deficit and in REIT Focus, analyze Digital Realty Trust, Inc., a data center industrial REIT. RANDOM RAMBLINGS I was saddened to learn that the real estate brokerage firm of Grubb & Ellis ( G&E) filed for bankruptcy protection last month and was sold to an investment firm. The assets were sold to BGC Partners, the owner of a competing brokerage firm, Newmark, Knight, Frank. When I was a young real estate turk in the eighties, G&E was the prominent real estate brokerage firm in the country, especially on the West Coast. Many of my early acquisition and financing deals came from G&E and there were some great real estate brokers at the firm. One deal in particular brokered by G&E, was a difficult $12 million loan from Household Finance on an office building in Long Beach, CA. G&E s downfall was due to three factors. First, was poor management, primarily by Michael Kojaian, a Detroit real estate investor, who acquired the firm in 1996 and basically ran it into the ground. During the last ten years, G&E had at least six different CEO s and none were able to grow and scale the business to compete with CBRE and Jones Lang LaSalle. Second, was the acquisition of TNNN Properties, a high flying CA based syndicator of tenant in common interests, controlled by Tony Thompson, at a very inflated price in The remnants of TNNN were sold in 2011 for a fraction of the acquisition price. Lastly, this deep and prolonged real estate and financial depression that has reduced the volume of sale, finance, lease and management transactions, the lifeblood of a real estate broker, by 75% since In its heyday in the 1980 s and 1990 s, G&E had more than forty offices, thousands of employees and completed billions of dollars of transactions. It s a sad commentary on the CRE industry to see them go.

2 REAL ESTATE RISK Real estate risk is defined by Wikipedia as, the potential that a chosen action or activity (including the choice of inaction) will lead to a loss or an undesirable outcome. In CRE, risk can be the loss of equity or profit in a deal, the loss or bankruptcy of a major tenant, an increase in the interest rate or cost of a loan and a negative changes in the market where a property lies. All of these are just some of the risks inherent in CRE. A more comprehensive list of CRE risks would include the following: Cash flow risk (volatility in the property s cash flow) Property value risk (reduction in a property s value) Tenant risk (loss or bankruptcy of a major tenant) Market risk (negative changes in the local market) Economic risk (negative changes in the macro economy) Interest rate risk (an increase in interest rates) Inflation risk (an increase in inflation) Leasing risk (inability to lease vacant space or a drop in lease rates) Management risk (poor management) Ownership risk (loss of critical personnel) Legal and title risk (adverse legal issues and claims on title) Construction risk (development delays and payment defaults) Entitlement risk (inability to obtain projected entitlements) Liquidity risk (inability to sell property) Refinancing risk (inability to finance property) As you can see, CRE is subject to many risks and usually more than in a lot of other industries and businesses. However, when evaluating risk, an investor or developer must also consider the return on the asset for the given level of risk. If a property can be purchased at a 10% cap rate, that doesn t reveal if it s a good or bad deal, because we don t know the risk profile. If it s a single tenant net lease deal with a shaky tenant that may file bankruptcy, then it s not an attractive investment. If the property is net leased to an AA rated tenant for twenty years, then it would be an attractive deal. The question that real estate investors need to ask is, is the cap rate or IRR high enough to invest in this property, given the level of risk? I don t think many investors consider the risks in CRE when making an investment. Many look at the cap rate and maybe the price per unit or square foot and if they have the debt and equity capital will make the investment. During the last seven or so years, the primary consideration in buying a real estate property was whether the funds were available. This irrational investment process happens during every CRE boom and many of those investors end up either loosing property through foreclosure or bankruptcy. There is usually very little regard for a risk adjusted return analysis as promulgated by modern portfolio theory. In modern portfolio theory, there is a term called, the security market line, ( SML ). The SML is a line that graphs the market risk and return of an asset or portfolio of assets. It is part of the capital asset pricing model, ( CAPM ), which is a formula that describes the

3 relationship between risk and expected return and used in pricing securities. The CAPM formula is as follows: R=Rf+B(Rm-Rf) R-Expected return Rf-Risk free rate of return of US Treasury securities B-Beta or the measure of volatility of a security as compared to the market Rm-The expected market return Below in table I, is a graph of the SML for a real estate investment with a risk free rate of 2%, which is the current rate on 10 year Treasury notes and two other (1&2) potential SML s with different risk and return profiles. Table I, SML Lines for Real Estate Investments As shown in the table, the SML1 investor prefers a higher return for the same level of risk as compared to the SML2 investor. A real estate investor s SML can be at any slope on the graph, however, too many investors have a low sloping line similar to SML2. In today s apartment investment market for example, SML2 is an investor buying a CA apartment complex at a 4.5% cap rate and SML1 is an investor buying a similar complex at a 7% cap rate. Who is right in their investment decision? We won t know for sure until the properties are sold, but the SML2 investor has a much higher initial cash flow and lower basis to absorb all the applicable risks as compared to the SML1 investor.

4 CRE risk associated with an investment can almost always be equalized through the price. A real estate asset is only risky in relation to its price or value. Fixed income investors are shunning new Greek bonds today like the plague, but would they be buyers at a price of 10 cents on the dollar? Maybe so, if in their mind that is the price they need to bear the high risk of default. CRE should be no different, but the price of the property is not often seen as the risk equalizer. Many large institutional and otherwise astute investors bought Class A office buildings and apartments at 5% cap rates during the boom, only to default and give the project back to the lender four years later. These deals had low sloping SML s, like SML2 above. If price was the equalizer for all the potential risks in CRE, then few of those overpriced deals would not have been bought at inflated values. CRE investors that are successful in the long run buy great deals not great assets. ECONOMIC FOCUS According to Zero Hedge ( an excellent web site on Wall Street and the economy, the US budget deficit for February hit a record $232 billion. Yes, that s for just one month, not a quarter. In the first five months of the 2012 fiscal year, the US has racked up a deficit of $580 billion or almost $1.4 trillion on an annualized basis. The total US debt is now more than $15.5 trillion (that s 15 with twelve zeros). Am I the only one that thinks we are headed for a Greece like train wreck? Remember also, that due to the Feds zero interest rate policy, the annual interest cost on all this debt is approximately 1.5% or about $275 billion per year. What happens if by some miracle the economy really starts growing at a normal GDP of 4% or 5% and interest rates start to rise? The interest component of our debt will increase exponentially. I think the absolute numbers of our debt are so large that it will be impossible for the next Congress to increase revenues or cut spending and that it will be forced on us in the next few years by the market. There is a term in economics called Financial Repression. This refers to several schemes used by a government that either forces or channels investor capital to themselves by buying government securities. This allows indebted governments to keep issuing debt at lower interest rates than would otherwise be possible. The low nominal interest rate helps the government to reduce its debt service costs and fund its operations. The current zero interest rate policy and negative real rates have forced many people and investors, especially seniors and those on fixed incomes, to invest in government securities in a form of Financial Repression. With a total debt of $15.5 trillion, this is a very scary scenario and one we will keep harping on here at VOM.

5 REIT FOCUS This month s REIT Focus is on Digital Realty Trust, Inc. ( DLR ). DLR is a selfadministered and self managed Maryland real estate investment trust that is the 95.6% owner of the general partner interest in Digital Realty Trust, L.P., the UpReit partnership that owns the assets of DLR. DLR engages in the ownership, acquisition, development, redevelopment and management of technology-related real estate. It focuses on strategically located properties containing applications and operations critical to the day-to-day operations of technology industry tenants and corporate enterprise datacenter users, including the information technology departments of Fortune 1000 companies, and financial services companies. As of 12/31/11, DLR owned 101 properties, with 84 in the US, 15 in Europe, 1 Asia and 1in Canada. These properties contain approximately 18.3 million square feet of data center space including 2.4 million square feet in development. DLR owns its properties in various markets with Silicon Valley, CA containing the largest amount at 13.3% (by percent of total rent), 10.4% in Northern Virginia and 9.8% in San Francisco, CA. The two largest tenants are Century Link, Inc. with 33 locations, 2.7 million square feet of space, representing 16.9% of total square feet and Equinix Operating Co., Inc., with 9 locations, 878 thousand square feet and 5.5% of total square feet. DLR was incorporated in the State of Maryland in 2004 and is based in San Francisco, CA. As of 12/31/11, the average occupancy and monthly rental rate were, 94.8% and $52 per square foot, respectively. As of 3/15/12, DLR had million shares outstanding, a stock price of $72/sh. and a market capitalization of approximately $7.7 billion. Select financial data for DLR as of the 12/31/11 10K and for the year period 1/1-12/31/11 is as follows (in thousands where applicable): Real Estate Assets, Gross $6,119,000 Total Assets $6,098,000 Mortgages, Senior Debentures & Credit $2,940,000 Facilities Stockholders Equity $2,553,000 Revenue $1,063,000 Net Income $131,000 Earnings Per Share $1.32 Cash Flow from Operations $401,000 Global Credit Facility ($1.2 billion available) $1,500,000 Market Capitalization $7,700,000 Debt to: Market Capitalization (equity value only) 39% Assets 48%

6 Real Estate Assets Per Square Foot $334 Dividend Yield ($2.92/sh) 4.10% NOI and Value Calculation: Revenues Per Above $1,063,000 Less: Rental and Operating Expenses ($440,000) Net Operating Income Annualized $623,000 Projected Inflation Rate 103.5% Projected NOI for 2012 $645,000 Projected Cap Rate 8% Projected Value of Portfolio $8,062,000 Less: Total Debt & Preferred Stock ($3,510,000) Projected Value of Company Equity $4,552,000 Shares Outstanding 107,100 Projected Value Per Share $42 Market Price Per Share (3/14/12) $72 As shown above, our value for DLR is $42 per share versus the market price of $72 per share. A portion of the value difference can be attributed to projecting a forward one year net operating income. The market however, is valuing the company at a cap rate of approximately 5.8% which we believe is too rich for a data center owner and developer. Our cap rate of 8% is in line with the average cap rate for industrial type properties per a CBRE 2011 cap rate survey. DLR has been in a high growth mode with net income increasing over 178% and the stock price up 44% since DLR is considered a well managed REIT, in a hot sector with a solid portfolio of data center type properties. However, we believe that the market price of the company s stock at $72/sh. is too overpriced for investment even though it currently yields a solid 4.1%. We do recommend acquiring the stock on any type of price pullback. REIT Focus reviews in prior issues of VOM are as follows: 1. BRE Properties, Inc., June 15, Boston Properties, Inc., July 15, Simon Properties Group, Inc., August 15, First Industrial Realty Trust, September 15, Public Storage, October 15, Ashford Hospitality Trust, Inc., November 15, AvalonBay Communities, Inc., December 15, 2011

7 8. Alexandria Real Estate Equities, Inc., January 15, Federal Realty Investment Trust, Inc., February 15, 2012 THE VIEW OF THE MARKET NEWSLETTER ARCHIVES Copyright Paramount Capital Corporation 2012 Disclaimer: The information, strategies and material presented in the newsletter are for information purposes only and not to be considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments. This newsletter is available only by paid subscription and should not be reproduced, copied, ed or disseminated in whole or in part without the express written consent of Paramount Capital Corporation.