Keep Your Eye On The Horizon

A crucial part of investing is to look in all directions towards the horizon. By that I means forwards as well as backwards, since it is both anticipation and retrospective understanding that enable us to increase our ability to make the best decisions.

The best traders and investors are those who adapt fastest from mistakes - and learn from them. It is not about selling when an unrealised loss reaches a huge number for example, but determining whether that situation will recover, or if it is indeed time to cut your losses and analyse what went wrong.

"Indeed one's faith in one's plans and methods is truly tested when the horizon before one is the blackest." Mahatma Gandhi

Hence why my focus on General Growth Properties intensified as its stock price fell throughout Q1 2009. As we know, everything so far has gone well for GGP as an investment recently, but it is well worth spending time re-assessing the stock now.

How exactly does it stack up relative to its peers on current valuations? What are the likely prospects regarding securing advantageous terms with lenders ahead of submitting a reorganisation proposal to the Court? What are the primary risk factors remaining (e.g. dilution), and what is the likely price range in 12 months? Take a look at this table of the American REIT Peer Group, which details the share price performance of GGP relative to its peers over the last 3-12 months.

The statistics speak for themselves as to which has been the best hold over the last 6 months, with GGP up a massive 403.20%. Having said that, this is in no small part due to its enormous discount due to bankruptcy risk - hence the 87.90% year-on-year fall.

For a selected group I have added in some analyst FFO estimates for 2009/10; firstly note the zero 6 month dividend yield - a shame for those of us with plenty of shares. One of the most striking observations is when we look at the forward NAV (Net Asset Value), this reflects GGP's market value based on its real estate properties, and the figure is derived from the total number of shares. At just 3.5, this is a massive 14.8x lower than Simon Property Group, and 8.4x lower than Regency. Why is GGP so much lower? The primary reason remains the uncertainty forward priced due to its status in Chapter 11, and its ability to secure asset prices or cap rates.

However looking at the sector as a whole, commercial real estate has gone through a rally that has pushed up valuation levels to near previous peak levels. If we take a benchmark (EV/EBITDA is more accurate the P/E ratios for REIT's) then the sector average is at a multiple of 14 right now. That gives an implied cap rate in the 6-7% range. However that also means that as on average, REIT's are now averaging 12.8X the 2010 Funds From Operation (per share) estimates - strikingly that is a 23% premium to long-term average multiples.

That actually suggests that for short term traders, now is not necessarily a good time to be entering commercial real estate. However if we go back to GGP, the enormous discount to the sector becomes apparent. At just a 1.5x 2010 FFO/share estimate, it sits markedly as by far the cheapest in the sector, and suggests that should restructuring complete without excessive share dilution - something I will come back to another time - then this clearly remains THE choice in the sector for value investors.

This recent commentary has suggested that the recent ruling on GGP should be considered a one off "largely because [the whole company] has filed for bankruptcy." I think one off is the wrong phrase, what they actually mean is that given most defaults are not at the parent entity level, therefore single entity defaults will not provide any opportunity for debtors to push for the kind of ruling that has just taken place with GGP.

However many other companies operate with a centralised cashflow model, and so could conceivably see similar group wide liquidity problems, so to claim this is a one off is not correct. In fact, this view is shared by the legal firm Wachtell, Lipton, Rosen & Katz, which notes:

"..the GGP ruling may herald a trend towards bankruptcy filings by highly structured commercial real estate enterprises which today find themselves vastly over-levered."

The article is well worth reviewing, as it provides some observations around how the complexity of debt tiers acts in itself as an incentive to file for Chapter 11 due to problems restructuring:

"Further fueling potential bankruptcies, many of the highly structured, multi-tranche capital stacks that were set up in the last few years present significant barriers to consensual restructuring outside of bankruptcy. For one, master servicers and special servicers are often constrained in their ability to modify loans because of restrictions under the relevant pooling and servicing agreements and adverse tax consequences under applicable REMIC tax rules."

So with GGP remaining excellent value, I think the right balance of caution about GGP's future is struck with this final passage:

"While this round went to GGP and against the SPE and CMBS lenders, it remains to be seen where the balance struck by the GGP court between creditors’ rights and the interests of equityholders leads when thorny issues such as cramming down secured lenders to extend maturities and alter pricing and other terms to the benefit of equity are presented to the court, or how negotiation and settlement discussions – both in formal bankruptcy proceedings and in consensual non-bankruptcy restructurings – will play out in the post-GGP era."

Another legal commentary by Davis Polk of the recent court ruling is also available here which gives a good summary.