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

By: Reggie Middleton | Thu, Oct 22, 2009
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We have taken a 2nd look at the concerns raised by Ackman now that we have a copy of his short thesis on Realty Income (O) in PowerPoint (ackman-realty-income-short 21/10/2009,14:14 645.84 Kb) and have come up with the following observations. For those who do not subscribe to my blog, I have decided to make a significant portion of my real estate analysis available to the public, so as to fully communicate the apparently unforeseen cash flow and valuation situations of some of these REITs. This is in anticipation of a slew of fresh REIT short candidates to be delivered to subscribers in the upcoming weeks. I feel the sector is ripe for a revisiting in terms of valuation, cash flow issues and macro outlook. For part one of my review of Ackman's "Realty Income (O)" opinion, click here (requires a quick, "free" registration): Realty Income Preliminary Review 2009-10-08 01:27:59 1.35 Mb.

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

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

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

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

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

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

Assumptions for the above cash flow projections are:

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

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

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

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

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

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

MAC Intelligence Note - 1Q09 Earnings 2009-05-12 10:01:36 307.68 Kb
Macerich Forensic Valuation - Professional 2009-02-23 12:00:00 344.92 Kb
Macerich Sensitivity Analyis - Pro
Macerich Statistics Spreadsheet - Pro 2008-11-07 12:26:19 356.00 Kb
Macerich Summary 2008-10-09 09:27:51 910.94 Kb

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

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

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

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

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

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

ACC 2Q09 results review 2009-08-12 01:25:50 110.50 Kb
American Campus Communities Summary Preview - Pro 2009-03-09 00:40:22 436.84 Kb
American Campus Communities Property Analysis 2009-03-26 23:28:27 19.56 Mb
American Campus Communities (ACC) Forensic Summary 2009-03-23 00:21:15 538.57 Kb
ACC Summary Professional Addendum 2009-04-01 14:30:07 292.43 Kb
ACC May 2009 Intelligence Note 2009-05-04 11:59:26 414.74 Kb
ACC First Quarter 2009 Results 2009-04-30 12:27:03 381.58 Kb
ACC Intelligence Note - Q1 2009 update 2009-06-24 01:32:30 289.92 Kb
ACC 2Q09 results review 2009-08-12 01:25:50 110.50 Kb
ACC 9-09 research note 2009-09-24 12:31:24 1.03 Mb - this is the most recent update on ACC.



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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