Colonial Properties Trust: Value in the Real Estate Apocalypse

Mar.11.09 | About: Colonial Properties (CLP)

Very few investors want to touch REITs right now and that’s one of the reasons I find myself suddenly intrigued by them. While there are overleveraged REITs out there that may indeed be insolvent, my hypothesis is that there are also some REITs to be had at bargain-basement prices. The primary attributes I have been seeking out in REITs are as follows:

  1. Relatively low leverage
  2. Insider buying and a substantial amount of inside ownership
  3. High levels of liquidity
  4. Properties in markets near a bottom
  5. Strong asset quality on Balance Sheet

It is difficult to find any REITs that meet all of these specifications. However, finding some that meet a few of them could lead to some underpriced values. Recently, I examined Winthrop Realty Trust (NYSE:FUR), a REIT that I believe may provide some potential value to contrarian investors. Now, I want to take a look at another intriguing REIT, Colonial Properties Trust (NYSE:CLP).

Issues and Potential

First off, a quick look at Colonial’s balance sheet and most recent earnings call hardly inspires confidence. It’s obvious the company is bleeding at this point, as CEO Thomas Lowder’s five point plan discussed in the most recent earnings call demonstrates. Colonial’s low liquidity levels also should be a major source of concern. Discounting its “Restricted Cash”, I calculate a quick ratio of 0.29. That’s extremely low.

Despite these obvious issues, this does not necessarily mean that Colonial provides no value to investors. In fact, one of the things that led me to investigate Colonial further was a high amount of insider buying. Apparently, a lot of people inside the company believe the stock is underpriced and are willing to put their own money on the line to buy in.

Colonial’s Business and Properties

Colonial owns and operates a large number of residential communities, plus some office realty and retail space. The distribution between the different sectors is critical to me right now because the outlook for REITs operating in the residential sphere would appear to be better in the upcoming years than ones operating in the commercial sphere. Colonial has both residential and commercial properties, but seems more concentrated in the residential sector.

Another thing that seems important is the potential for further deterioration in property values. Unfortunately, this is a difficult thing to dissect given Colonial’s spread out portfolio of properties. Of note, the company does have many properties in Orlando, FL; Phoenix, AZ; and Las Vegas, NV. I have some fears that these areas might have considerable downside left.

I also have concerns about the large number of properties in Charlotte, NC and some of Colonial’s Atlanta, GA properties. The Charlotte properties scare me because of Charlotte’s high unemployment rate. Given Charlotte’s arguable status as America’s #2 banking center, I’m not sure I’d want to own property in Charlotte right now. Moreover, my own hypothesis is that the Atlanta suburbs are sprawled out in an unsustainable manner and rising gas prices will eventually led people back inwards; which could hamper suburban prices some, but could also drive property values inside the Perimeter upwards at some point.

It should be noted that only about half of Colonial’s properties hit my radar screen for further substantial price deterioration. They do have a number of properties in areas where I have lesser concerns and it’s possible that some of the properties in areas already mentioned are relatively close to bottoming.

Impairment Testing

With a lot of REITs, I like to look at their assets and consider ways the values could continue to be impaired. Given that over 94% of Colonial’s total balance sheet asset value comes from real estate, it is necessary to make very substantial asset impairments. Whether or not the company’s current stock price is justified depends on how much we can expect further deterioration in their real estate (RE) portfolio.

Right now, the book value (BV) of Colonial is about $20.50 per share; the stock sells at a significant discount to that in the $3 to $4 range. However, a large minority interest makes a straight-forward calculation more difficult. Rather than trying to get a completely “accurate” impairment, I’m going to estimate and play things a little bit on the conservative side for my impairment test.

Here’s a table documenting my results:

Impairment %

Total Impairment Charge

Adjusted Stockholders’ Equity

Adjusted Book Value

10%

$247 million

$758 million

$15.47

15%

$370 million

$635 million

$12.96

20%

$494 million

$511 million

$10.43

25%

$618 million

$387 million

$7.90

30%

$741 million

$264 million

$5.39

35%

$865 million

$140 million

$2.86

40%

$988 million

$17 million

$0.35

50%

$1.235 billion

($230 million)

($4.69)

Click to enlarge

All figures are approximate

While this is only a first step in deriving probable values for Colonial’s equity, it does show us how further deterioration in the RE market might impact its asset values significantly. If its overall portfolio bottomed out at a 20% decline, for instance, this could be a considerable value since the stock is selling well below the net tangible assets and our adjusted book value. On the other hand, a 40%+ decline in CLP’s RE assets could mean huge troubles are ahead.

Future Cash Flows

The other important thing to consider is how profitable or unprofitable an operation Colonial will be in the future. It’s worthwhile to note that CLP’s free cash flows (FCFs) were still positive in FY ’08. Including its property acquisitions and tenant improvements in the calculation for CapEx, I came up with FCFs of around $1.69 per share for FY ’08.

FCFs in prior years might be a bit deceiving since the company had high acquisitions during the height of the real estate bubble. Going forward, it might be more realistic to look at its operating cash flows. Those break down as follows for the prior three years:

Fiscal Year

Operating Cash Flows per Share

2008

$2.41

2007

$2.02

2006

$3.51

Click to enlarge

All figures are approximate

From Colonial’s most recent earnings call, we also learn that Funds from Operations (FFOs), excluding impairments charges, were $1.67 for FY ’08 and $0.32 per share for the quarter. As it is difficult to make future projections about cash flows in the current environment in the real estate market, I would simply make a very conservative estimate of future FCFs and our impairment-adjusted equity values to create probable values for the company.

The Quick DCF

For purposes of my analysis, I use a form called the “Quick DCF”. There are many ways to do a Discounted Cash Flow (DCF) analysis, but my quickie method allows for a ballpark valuation to be created with a minimum amount of time. The only things left I need to decide upon are free cash flows going forward and a cost of capital. I will assume a very minimal FCF growth rate of 3% and create four different scenarios:

Scenarios #1 and #2 will start with a $0.50 per share figure. Scenario #1 will use a 12% cost of capital (COC) while Scenario #2 will use a 16% cost of capital.

Scenarios #3 and #4 will begin with a $1.00 per share figure. Scenario #3 will use a 12% COC, while Scenario #4 will use a 16% COC.

My cash flow estimates for all scenarios seems conservative based on Colonial’s past performance, however, they may not be conservative enough when applied to the future. Not being an expert in REITs makes it difficult for me to say, especially given the huge diversity in CLP’s properties. Also, my cost of capital figures might seem very high, particularly given that they were recently able to secure a new credit facility with Fannie Mae with a fixed rate of 6.07%; however, my expectation is that costs of capital will rise significantly in the upcoming years.

Here are my estimated values using all four scenarios:

Impairment Charge %

Adjusted BV

Scenario #1

Scenario #2

Scenario #3

Scenario #4

15%

$12.96

$18.48

$16.80

$24.00

$20.65

20%

$10.43

$15.95

$14.27

$21.47

$18.12

25%

$7.90

$13.42

$11.74

$18.94

$15.59

30%

$5.39

$10.91

$9.23

$16.43

$13.08

35%

$2.86

$8.38

$6.70

$13.90

$10.55

40%

$0.35

$5.87

$4.19

$11.39

$8.04

50%

($4.69)

$0.83

($0.85)

$6.35

$3.00

Click to enlarge

All figures are approximate

It’s important to note that it would be unwise to take these figures at face value. Not only are they estimates, but in a worst-case scenario (such as a 40% - 50% decline in Colonial’s property values), it is very likely that Colonial would have to liquidate some of their holdings at a discount. In fact, Colonial is already trying to sell off some its properties to gain some much needed liquidity. But this does provide a handy table of potential valuations based on several possible outcomes.

The table shows how Colonial’s stock could be an absolute steal right now simply based on the value of their properties; it also shows how Colonial could still be overvalued in certain scenarios. A 40% decline in the value of CLP’s real property would almost certainly be disastrous, as even in my best case scenario, it’s unlikely that their cash flows would hold up in that environment; plus their cost of capital might be even higher than the 16% figure I used in Scenarios #2 and #4.

From these results, a 35% reduction in real property values would probably make the company unworthwhile as an investment, as well. It’s certainly a debatable point; its situation would be helped if it began disposing of assets sooner rather than later in such a scenario. However, it looks to me as if it might be able to absorb a 30% further reduction in RE prices assuming it sold off some properties in order to regain some much needed liquidity.

Plans Moving Forward

CEO Thomas Lowder’s five priorities for 2009 are as follows:

  1. Strengthen balance sheet by deleveraging the company via selling assets
  2. Improve liquidity; secure loans from Fannie Mae (FNM) and Freddie Mac (FRE); the CEO also believes that since over 90% of its assets are unencumbered, the company can continue to get attractive financing
  3. Addressing near-term debt maturities in ’09 and ‘10
  4. Reducing overhead, including workforce reductions
  5. Postpone developments

The company’s liquidity issue seems to be the most pressing one and its one reason to be pessimistic about its future. However, Colonial appears to have made the right move to sell off many of its commercial assets in ‘07 and focus on multi-family assets. While I mentioned some potentially problematic markets, I do like to see it operating in places like Richmond, VA and Raleigh, NC among others. Even in some of the markets that might still be in a bubble, the company could be in relatively decent shape, especially compared to other REITs out there.

Concluding Analysis

The question as to whether or not Colonial is a good value-stock is more difficult than my analysis for Winthrop Realty Trust (FUR). I can envision scenarios where even the current price is too high; however, based on my overall analysis, I believe this is undervalued right now, even if I don’t have a high level of certainty about that conclusion.

If you are in search of a low-risk stock with a guaranteed return, I would shy away from CLP. If you are a risk-taker, this might be the type of stock for you. It traded above $50 in 2007 and while it’s not going back there any time soon, I believe it’s possible that this could once again climb up as high as the $15 - $20 level, which would mean some huge returns, especially when you consider the dividend.

My suggestion is that if you own a highly diversified portfolio, you should consider a small purchase in Colonial Property Trust. I would not suggest a huge position given the risks. For my simulated portfolio at KaChing, my holdings in CLP constitute about 0.7% of my total long portfolio and I may increase that back up to 1%.

Overall, I would value this stock at $8 given my own observations, probable valuations, and perception of risks involved with the company. Over a five-year period, I’d assess downside risk at $0. Upside maximum potential might be around $25, plus at least $1 per share annually in dividends. If the dividends hold up relatively well for the next few years, that alone would cover the stock price; however, that might be a rather big *if*. Colonial looks like a good buy for the right portfolio.

Disclosures: Author holds no position in CLP.