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This month's REIT Focus is on Hudson Pacific Properties, Inc. (NYSE:HPP), a publicly traded, self-managed real estate investment trust that owns office buildings in California. HPP owns a 92.8% general partner interest in Hudson Pacific Properties, L.P., its UpReit general partnership. As of 9/30/12, HPP owned a portfolio of 20 office properties, two media/entertainment properties and land for development with a total of 5.4 million rentable sq. ft. The properties are all located in Northern and Southern California, including the cities of San Francisco, Beverly Hills, Los Angeles, Orange and San Diego. Major tenants include Bank of America, AIG, AT&T and Saatchi & Saatchi North America, Inc. The average occupancy and annual base rental rate of HPP's office properties as of 9/30/12 were 80% and $26, respectively and of the media/entertainment properties were 71% and $34, respectively. HPP was incorporated in the State of Maryland in 2009, is traded on the NYSE and is based in Los Angeles, CA.

HPP has 46.7 million common shares outstanding (excluding a shelf offering of 9.2 million shares sold at $21.50/sh. on 2/12/13) and a market capitalization of approximately $1.04 billion. HPP has an experienced, although California centric, management team that includes Victor J. Coleman, Chairman and CEO, a former executive of Arden Realty, Inc., Howard S. Stern, President, also a former executive of Arden Realty, Inc. and Mark T. Lammas, CFO, a former executive of Maguire Properties, Inc.

Select financial data for HPP as of the 9/30/12 10Q and for the period 1/1-9/30/12 is as follows (in millions where applicable):

Real Estate Assets, Gross$1,259
Total Assets$1,345
Notes Payable, Secured and Unsecured$359
Stockholders' Equity$850
Revenue$121
Net Loss($11)
Loss Per Share($.28)
Cash Flow from Operations$40
Senior Unsecured Revolving Credit Facility ($250 with $10 used)$240
Market Capitalization$1,040
Debt to:
Gross Real Estate Assets28%
Market Capitalization34%
Real Estate Assets Per Sq. Ft.$233
Dividend and Yield ($.50/sh.)2.3%
Valuation Methodology:
Revenue Per Above Annualized$161
Less: Operating Expenses (excluding depreciation, amortization, interest expense plus other income, net)93
Projected Net Operating Income 2012$68
Projected Inflation Rate at 3.5%x103.5%
Projected Forward NOI for Next Year$70
Projected Cap Rate7.5%
Projected Value of Real Estate Assets$933
Add: Net Operating Working Capital87
Add: Sunset Bronson Vacant Land Estimated at $50 per FAR Sq. Ft.3
Projected Asset Value$1,023
Less: Total Debt Per Above($359)
Less: Series B Preferred Stock($145)
Less: Series A Preferred Units($12)
Projected Net Asset Value$507
Shares Outstanding (common stock, 46.7M shares plus operating pship units, 2.4M shares)49.1
Projected NAV Per Share$10.32
Current Market Price Per Share$22.05

As shown above, our value for HPP is $10 per share versus a market price of $22 per share. Current average cap rates for office properties per CBRE, Price Waterhouse Coopers and the Real Capital Analytics are in the 6% to 9% range, depending on the location, tenancy and quality of the property. We have used a cap rate of 7.5% due to HPP's portfolio being primarily Class B properties, (with some needing redevelopment), even though some buildings are located in the tighter office markets in California, like San Francisco and West Los Angeles. At its current price of $22 per share, HPP is trading at a 4.6% cap rate and is significantly overpriced for a small nondiversified office REIT.

HPP's strengths include; low leverage at 28% of asset cost, good asset growth and majority of portfolio is located in the robust San Francisco office market. Weaknesses include; portfolio is not diversified into non California markets, low average occupancy, low dividend yield of 2.3% and high priced stock.

All HPP's assets are located in California, which is currently experiencing a very soft economy due to high taxes, over regulation and high living costs. California's tough economy is driving many companies and individuals to flee the state for lower taxed and less regulated states like Nevada, Washington, Arizona and Texas. Even though California is headquarters to a number of Fortune 1000 companies, many are not expanding in the state. This trend, along with very tepid job growth, affects the demand for office space and the valuation of office buildings in the state. Although HPP is a newer and growing REIT, we do not recommend the purchase of the stock at this inflated price. Even if the price was at or near our valuation of $10 per share, we would still not recommend the stock until its investment strategy is expanded to include office building investments in other states. An asset diversification strategy with investments in other states would reduce HPP's overall portfolio risk and reliance on California's struggling economy, increase growth prospects, expand the market for building acquisitions and increase cash flow.

HPP's financial statement disclosures need to be expanded as there is no information and calculation of funds from operations (FFO) and projected cost and value of redevelopment programs.

The gross real estate assets, net income and cash flow from operations for 2010 to 9/30/12 are shown in the table below:

(millions)201020119/30/12 (9mos)
Gross Real Estate Assets$864$1,060$1,259
% ChangeNA22%19%
Net Income($3)($10)($11)
% ChangeNANANA
Cash Flow from Operations$8$32$40
% ChangeNA300%25%

A five-year price chart of HPP is shown below:

(click to enlarge)

Source: REIT Focus: Hudson Pacific Properties, Inc.