Lexington Realty Trust: High-Yield Opportunity, Ready for 2009

The first REIT that I’m taking a closer look at is Lexington Realty Trust (NYSE: LXP). Lexington Realty Trust owns 288 properties totaling 48.8 million square feet in 44 states. The company focuses on triple-net leased properties, which would normally suggest a high percentage of retail properties. However, Lexington’s portfolio is 74% office, 18% industrial, and 8% retail. At the end of its most recent quarter, its portfolio was 93.8% leased.

Cash Flow

Lexington reported Funds from Operations of $43.3 million or $0.40 per share in the third quarter. The previous year, the company reported $50.4 million in Funds from Operations or $0.46 per share. Across its portfolio, Lexington reports $442 million in annualized cash rent from its 48.8 million square feet of space, approximately $9.06 per square foot. Total vacant square feet of three million increases operating costs (as it does not receive reimbursements), and drives down the rental rate per square foot.

The cost of annualizing property-operating costs comes to about $81 million in expenses. General and administrative expenses basically cover management of the properties and corporate overhead. These costs are approximately $34 million on an annualized basis, or 7.7% of annualized lease income. This would be considered high on a property-by-property basis as a stabilized; triple-net leased property would general have a management fee of 2-3%. The additional expense is likely the result of running a publicly traded REIT plus value creation strategies such as property development activities.

I’ll assume (very conservatively) that rent on vacant space can be leased for $10.00 per square foot, triple-net for the remaining space. I back this out again, but I’d like to keep it as a separate item for now. A simple cash flow statement looks like this:

Gross Potential Rent: $472 million
Less Vacancy: ($30 million) - 6.4%
Effective Gross Income: $442 million

Operating Costs: ($81 million)
Management and Admin: ($34 million)

Net Operating Income: $327 million
Debt Service: ($149 million)
Net Cash Flow After DS: $178 million

DSCR: 2.20x

At $178 million, FFO per share would be $1.62. Lexington has guided between $1.56 and $1.64 per share for 2009.

Leverage

I believe that the value of Lexington’s real estate holdings is worth a bit more than cost. Total real estate holdings are listed at $3.8 billion on its balance sheet. Assuming an 8.00% capitalization rate, which is still conservative despite the general economic conditions, its real estate portfolio is worth $4.1 billion. This value, too, may be understated, as administrative and corporate overhead is included in this number. Also, keep in mind that Lexington successfully sold 15 properties last quarter at an average capitalization rate of 6.6%. The value per square foot based on the $4.1 billion value is $84. Again, a very conservative estimate of value considering Lexington’s portfolio is 74% office.

Lexington has debt outstanding of just under $2.5 billion, indicating a loan to value ratio of 61% based on fairly conservative assumptions. All of this excludes the $135.5 million in cash that the company held at quarter-end.

Portfolio Risks

According to presentation material on Lexington’s web site, 53% of its tenants are investment grade, 32% are unrated, and 15% are non-investment grade. The company has exposure to Daimler-Chrysler (DCX), Tower Automotive, Dana (DAN), Tenneco (TEN), Circuit City (CCTYQ.PK), and Bally’s. Dana Corp., for example, represents 2.2% of its tenant base. Potential lease defaults from these and other non-investment grade tenants could certainly result in additional vacancy at a time when leasing is more difficult.

More than anything else, the significant decline in Lexington shares is likely due to $267 million in debt maturities due in 2009. Financing has rapidly become scarce over the last year, and financing that seemed like a sure bet 18 months ago is now in question. However, in the company's third quarter press release, Lexington noted that the gross book value of properties securing these loans is $1.4 billion, and the annual cash revenue produced by these properties is $121 million. An 8.0% cap rate suggests a portfolio value of $1,512 million based on this rental income. Based on the $1.4 billion gross book value, the loan to value ratio for this portion of its portfolio is 19%. Even in these times of scarce financing, it seems likely that Lexington could find financing for this portion of its portfolio.

Stressed Cash Flow

Lexington has done a good job in maintaining occupancy rates through 2008. Many markets have seen vacancy rates rise over 2% since the middle of 2008, yet Lexington noted that it leased 770,000 square feet in the third quarter and by the time of its earnings report had leased 1.3 million more square feet. This is impressive in this market.

In its supplemental information, Lexington notes that 25 leases representing 9.0% of its portfolio cash flow expires in 2009. In my stressed cash flow below, I will assume that none of this is re-tenanted in 2009, and I will assume that an additional 5.0% of space is lost to tenant defaults.

Gross Potential Rent: $472 million
Vacancy: ($95 million)
Effective Gross Income: $377 million

Operating Costs: ($81 million)
Management and Admin: ($34 million)

Net Operating Income: $262 million
Debt Service: ($149 million)
Net Cash Flow after DS: $113 million
DSCR: 1.76x

FFO/share: $1.03

Dividend Outlook

As noted above, Lexington announced that it is cutting its dividend back to $0.72 per share in 2009. Based on my stressed cash flow scenario above, it looks like this dividend level is very safe. Excess cash flow will be used to support de-leveraging of the company.

In the long term, Lexington looks to have plenty of room for increasing dividends beyond 2009. At its recent share price of $5.00 per share, the current yield is 14.4%.

Company Strategy Amid Crisis

2008 has been a year where every financial company has been in a race to reduce leverage, and Lexington has been no exception. However, I am impressed by how opportunistic the company has been in achieving these ends. Asset sales at a 6.6% cap rate certainly do not look like a fire sale. It looks like the company achieved some good prices. The company plans to market $400 million in properties for sale in 2009 not because it has to, but because it sees an opportunity to repurchase debt at a discount.

During the third quarter, Lexington repurchased $25.5 million in exchangeable notes at a 10.7% discount. Subsequent to quarter-end, an additional $32 million in exchangeable notes were repurchased by the company, which resulted in a yield to maturity of 16.3%. The debt markets are certainly not nearly as efficient as the real estate market. Returns in commercial real estate are nowhere near 16.3%. Lexington has taken advantage of this opportunity.

Conclusion

In a recent post, I noted that REITs could be a high-yield opportunity in this market. Lexington certainly appears to have conservative leverage levels and a smart strategy for dealing with this crisis. Debt maturities in 2009 appear to be mitigated by extremely low leverage levels. Portfolio occupancy is also mitigated by relatively low debt levels. Even if portfolio occupancy falls from 93.8% to 80%, Lexington can still meet its dividend level in 2009 and beyond.

Disclosure: I have no position in Lexington shares.

Comments

[doubled:]

I agree with this analysis but of more interest is the fact that LXP has 3 seperate preferred issues, series B, C, and D. All are cumulative preferred and the C has a convertible option. All of these preferreds are publically traded and listed on NYSE. They currently have dividend yields which are above the level of the common yet are in front of the common in terms of payment preference. They also have a $25 par value and based on their current prices there is as much upside in these preferreds as there is in the common. Investors interested in LXP should look at the preferreds as the market is currently giving them away and they are a better deal.

Jan 07 09:00 AM

[Sunil Suri:]

Dan, you have it mightily wrong -

If you look at their 10Q for 9/2008, the 'consolidated' gross rent annualized going forward is only $376MM, and reported Operating Income of $304MM.

Since they say they currently buy NNN assets at about 8.5% cap (and which is about right, for their properties are 'industrial/office' type assets and NOT Class "A" office (a La Boston properties or Vornado) - so after deducting for about 7% vacancy (which has been historically close to reasonable - except now a days running closer to 11%), one gets an adjusted triple net income of about $278MM for annualized 2008, and a 'consolidated' value (from which we must deduct minority interest for all consolidated entities - and this is about $625MM), we get a net asset value as of 9/2008 of only $2.64B. And this presumes that rentals do not fall through the re-lease cycle - and this is suspect as well. Rentals will be lower going forward for sure. And I am not deducting for tenant fit-outs and re-leasing commissions and potential loss of rent for down times and such - which by the way adds up to a fairly significant sum too!


On to the Balance Sheet, we find that there is about $329MM of cash and equivalents, accounts receivable and a cost value of about $205MM for investments in "subs" that are consolidated and debt (basic secured and unsecured debt + preferred shares), equals about $3.1B.

Thus if we were to add the value of the assets we get about $2.97B.

Thus net equity is only $103MM. Which by today's market value is trading at $500MM.

On a cash flow basis, if we take out the debt service and the preferred dividends, I doubt it if their FFO is sustainable and neither is the dividend as you state.

De-Leveraging shall hurt them mightily I believe - their assets are not the highest quality either and there is no equity, which even for the best REIT's should not drop below 40%!

Jan 07 09:16 AM

[BigOlDave:]

Nice recap, Dan

I own AHR. LXP has a better looking chart and, even with the reduced dividend, beats AHR -- it has suspended the common dividends (but not preferreds) to ease cash flow.

It would be good to get an analysis like this for AHR or the REIT you like best (is that LXP?).

Jan 07 12:24 PM

[Dan Wieman:]

Mr. Rufus

Thanks for your comments. I have to admit, my first reaction is that I'm wrong and you have found a flaw in my analysis. This is what is great about this forum. If people approach these articles with intellectual integrity, a great deal of learning can occur.

So let's step through the numbers and see where we end up...

I see where you get $376MM. You take reported gross rental revenue in the 3Q of $94,166M and multiply by 4. Fair enough. This represents gross revenue for the third quarter less vacancy. My cash flow analysis is equal to $442MM on this basis.

I will point toward the annualized cash rent in their consolidated portfolio of $387,868M on page 23 of their supplemental report. I then added $48,256M from their strategic asset portfolio. This looks like a mistake, because Lexington only owns a portion of this entity. I couldn't find the exact ownership interest, but their claim after preferred returns is 35%.

So gross revenue (assuming properties are fully leased) is as follows:

$388MM + 16.8MM = $404.8MM in Gross Potential Rent
Less Vacancy (6.4%) = ($25.9MM)
EGI= $379MM

So we're not too far off here. $376MM was based on annualized rental revenue, and $379MM is based on grossed up rents less vacancy. I want to do this so I have an accurate vacancy factor in my stressed cash flow.

Keep in mind that we have both excluded tenant reimbursements to this point. This would be about $44 million annualized. I left it out initially to be conservative. They get about half of their operating expenses back in reimbursements. Add this back and you get:

$451.6MM GPR
($28.9MM) Vacancy
$422.7 EGI

This looks pretty accurate. The expenses aren't really disputed. You did manage to apply vacancy to operating income, which already included vacancy. I assume you took 7% vacancy against $304MM, which already included vacancy, to get your $278MM in operating income. The rest of my income statement looks like this:

Operating Costs: ($81 million)
Management and Admin: ($34 million)

Net Operating Income: $307 million
Debt Service: ($149 million)
Net Cash Flow After DS: $158 million, FFO/Shr = $1.44

DSCR: 2.07x
Implied value at 8.0% = $3,838MM. LTV~66%.

Stressed:
$452MM GPR
($90MM) Vacancy
$362MM EGI
($115MM) op costs
$247MM NOI
($149MM Debt)
DSCR=1.66, FFO=$98MM, $0.90/shr

I still feel pretty good about my analysis. No doubt the market looks difficult this year, but I do not believe that the numbers look as dire as you indicate.

Thanks for your comments!

Dan

Jan 07 04:38 PM

[Chris B:]

The problem with buying a REIT right now is that many of their properties have lost 30-40% of their market value. But their stock valuations now reflect this right? Yes. But their valuations don't reflect the loss of competitive advantage and the likelihood of pricing pressure when upstart competitors can buy similar properties for 30-40% less, which would, in theory, allow them to set rents 30% lower and enjoy the same cap rate as their older competitors who bought at higher prices.

A very simplified example: If you bought a building in 2005 and the mortgage is $800/mo, you can't compete with someone else who bought an equivalent building for much cheaper in 2008 with a $500/mo mortgage and who can set the rent at $600/mo to attract a diminished number of tenents. At your $800/mo breakeven point, the vacancies are all yours, and your only option may be to sell or rent the property at a loss.

Reports of falling rents for offices and apartments confirm this phenomenon. Somebody is buying all those properties, and they're undercutting the publicly traded companies, even as customer demand declines.

Jan 08 05:35 PM