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January 06, 2008

The Commercial Real Estate Crash Cometh, and I Know Who is Leading the Way
by Reggie Middleton

A couple of weeks ago I informed BoomBustBlog.com readers that I was working on a big project concerning commercial real estate short candidates. I stated last year that I was sure CRE was headed down, hard. Well, I am now ready to start releasing the results of my research over the next week or so. Unfortunately, the market has moved against the subject of my research fiercely as I was completing it, but it appears to be far from over. Who is the subject of that research, you ask? General Growth Properties (GGP). I have actually seen this company pop up in the media and a few discussion groups from time to time, but they have no idea what the management of this company has been up to. First, a little background on how I got here. Those who are not versed in commercial real estate valuation are urged to read my quick and dirty primer on CRE valuation .

I told members of my analytical team to screen the commercial real estate trust, service, and development sector for the usual suspects, starting with the the guys that purchased Sam Zell's flipped properties from Blackstone. I made some of the companies available via blog post and download: Commercial Real Estate Cos. (43 kB). Forest City Enterprise Peer Comparison (198.98 kB), Vonardo Realty Trust (146.49 kB). After and exhaustive screen and resultant short list, we chose GGP. I then instructed the team to canvass local and national brokers (4), databases (5) and data aggregators (several) to get the most precise localized rental and expenses figures possible. This data, as well as purchase dates, prices, management actions, capital improvements, etc. were used to plug into models such as this 33 page illustrative example, GGPs Woodlands Village (612.34 kB), to ascertain the true value of GGP's portfolio. We also measured and valued their development operations, joint ventures, CMBS financing, off balance sheet vehicles and master planned communities. Sum total, I now have roughly 2 gigabytes of "REAL" valuation data on my servers covering 260 properties owned or partly owned by GGP. A this point, I may know more about their operations than they do.

What is more telling is the window of understanding this opens into the commercial real estate space in the US. It is my opinion that most are extremely over-optimistic regarding the prospects for this space.

An Overview of What I Found

1. Valuing the company - After including the proportionate valuation of the properties in which GGP has minority stakes, we got a total portfolio valuation of around $30 bn based on the NOI stream. Adjusted for the current o/s debt of $24 bn. The net valuation comes to $6.5 bn. Note this is nearly the same as the $6.6 bn. valuation based on CFAT (after debt service) stream as per the aggregation of the 260 individual valuation models, which lends signifcant credence to the numbers. Finally, including an estimated $2.8 bn for the PV of the stream of other income, the total valuation of GGP stands at $8.8 bn which is a 5% downside from the current market cap.
2. Our present rental growth assumptions are based on reasonable estimates of GDP growth, population growth and household income growth in the company's operating locations. We believe these assumptions represent a best case scenario. We have yet to build the impact of the slowdown over the last few months as reflected in falling retail sales and consumer spending. Incorporating these factors, valuation may decrease 10-15%. The worst case scenario assumptions considering expected recession conditions will drive valuations down to around 20%. This is probably mislabeled as "worst case scenario", since I strongly believe we are already in a recession - one that looks to be rather severe. We would incorporate the different scenarios and work out the precise numbers later on in the week. Keep in mind that I am being conservative here. My gut feeling puts these numbers much lower.
3. Referring to the Leverage portion of our models, we identified the properties with leverage higher than 80%. It can be observed that around 73% of such properties have negative PV based on CFAT (including debt service), validating the fact that highly leveraged properties are already running into negative values - and this is at the onset of recession - much worse is to come.
4. The Cap Rate Analysis in the same file shows that the properties purchased over the last 3-4 years are earning lower cap rates (3-4%) than those purchased in late 1990s and early 2000s owing to higher relative purchase prices in the last couple of years. Since a large lot of GGP's portfolio has been added in the last 3-4 years, the overall cap rate of the company is being negatively impacted by the lower cap rates for such properties. Further, with macro-economic conditions turning adverse, such properties may already stand overvalued in GGP's books and may soon turn into losses. Up until this point and as I did with the homebuilders, stated book was pretty much ignored and I went about constructing book value independently. I am now having the mod squad delve into the reported numbers for comparison's sake.
5. Another important observation is that around 100 properties (38% to 43% depending on how one includes ownership under JVs) have negative equity. Around 70% of those were acquired in the last couple of years (when credit availability was easy and cost of debt low), reiterating the finding that a large amount of these properties may be significantly overvalued in GGP's books.

We have also looked for the historical NAV trend for GGP. However, since NAVs are not publicly available (GGP does not report NAV for its portfolio), we haven't had much luck thus far. Specifically, the REIT NAVs computed by Green Trust Advisors, one of the most popular REIT investment advisory concerns, are also not publicly available for the recent periods. The latest NAVs we could find from this source were for early 2007 when GGP stock was trading at around 10% discount to NAV. However, we believe that due to the subsequent difficulties in the credit market, the situation may have reversed of late. I have the Mod Squad continuing to explore this area and will post the findings on the blog.

Other issues of note

1. Rise in Insider Transactions: There has been more than a couple of insider transactions for sale of company shares by senior executives in last 1-2 months. This may indicate GGP management's indirect response to overvaluation of company's share price at current levels of $39.36.
2. Huge Mortgage Obligations: The company has huge mortgage obligations (approx $24 bn as of Sep 30, 2007), due for payment in next couple of years. In view of the credit crunch in the global financial markets, the company would be mandated to refinance its financial liabilities at a considerably higher interest rate, thereby adversely impacting its cash flow.
3. Overvalued Stock: Based on our initial work on valuation of GGP, the company's stock seems overvalued by approx 15% at current level of around $40, indicating a minimum potential downside risk of $6 per share. Again, this is an optimistic scenario, excluding the possibility of recession. GGP is highly reliant on 2nd tier retail shopping centers and to a lesser extent Master Planned Communities. I expect both of these segments to take a bath in the upcoming years.
4. Property Overvaluation: Our working on individual property valuation indicates a number of instances where the Company's properties seem to be overvalued. These properties have mostly been purchased in late 2006 and 2007. There are also quite a number of such properties which were purchased in 2001 and 2002. This is paradoxical, since the commercial real estate was quite soft during this period. I consider it management's error to overpay for properties during an era when it should have been relatively easy to get the properties at decent prices. This could also be a result of mismanaging the properties as well.
5. Lower than expected 4Q2007 retail sales: Many US retailers have witnessed lower-than-expected sales in 4Q2007 owing to slow-down in US consumer spending. This may (most likely will) dampen demand for commercial rental space in the US, thereby creating downward pressure on commercial real estate rentals.
6. Stock Trading at 52 Week Low: The company stock is trading at 52 week low price of $39.36. Despite this, there is still noticeable insider selling.

The above observations are based on initial assessment and valuation of GGP properties in different geographies in the US, and we shall come out with some more and refined observations as we advance our research on the company.

Cap Rate Analysis

Equity Summary

Leverage Summary

Summary of GGP Valuation

GGP valuation on NOI basis	$
Consolidated valuation as per Portfolio Valuation sheet (NOI based)	30,553,483,142
less: Debt outstanding	24,073,812,000
Estimated portfolio PV	6,479,671,142
Add: PV of the other net income	2,383,540,286
Estimated valuation of GGP	8,863,211,429
No of shares	243,810,000
Estimated share price	36.35
Current share price	38.4
Upward (Downward)	-5.3%
GGP valuation on CFAT (after debt service) basis
Consolidated valuation based on CFAT (after debt service)	6,605,261,299
Add: PV of the other net income	2,383,540,286
GGP's estimated market cap (CFAT basis)	8,988,801,585

Read more on Commercial Real Estate and Residential Real Estate.

Reggie Middleton
http://boombustblog.com/

Reggie Middleton is the personification of the freethinking maverick--the penultimate nonconformist as it applies to macro strategies, investment, and analysis. He uses his background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation, and financial analysis to pursue, analyze, and capitalize on global macroeconomic opportunities.

Finding most available research lacking, both in quality and quantity, Mr. Middleton assembled his own talented research staff. As forensic research is a lynchpin for his own investing, "to actually put food on the table," he stands behind it as doing what it is supposed to do - illustrate, elucidate and educate.

He does not sell advice or research. He is an entrepreneur who exists outside of mainstream corporate America and Wall Street. This allows him the freedom to do things that many cannot--perform without conflicts of interest and corporate politics. He prides himself on developing some of the highest quality, actionable research available - regardless of price. He welcomes any and all to peruse his blog of freely available analysis, opinion and participatory social media; use his custom tools, download files, interact with the community and make critical comparisons from a results orientated perspective. Reggie believes ideas and implementations are improved and fine-tuned when bounced off of the collective intellect of the many, in lieu of that of the few - in essence, a form of collaborative open source financial analysis.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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