Since early March, I have postulated that the market has been overly punishing many quality REITs that could be had for sizable discounts. Thus far, I examined the following REITs in detail:
This is Part VI in my “Quest for REIT Value” series. For this article, I will focus on commercial REIT, Lexington Realty Trust (LXP). If you want to read another take on this REIT, I’d also suggest Dan Wieman’s article on Lexington from January.
In my prior articles, I have mentioned several factors I look for when examining REITs:
· ... Relatively low leverage
· ... Insider buying and a substantial amount of inside ownership
· ... High levels of liquidity
· ... Properties in markets near a bottom
· ... Strong asset quality on Balance Sheet
· ... Focus on residential RE over commercial RE
There’s a solid case that Lexington qualifies for the first five of these prongs. With a 63% Liability/Value ratio, Lexington is one of the least levered REITs on the market. While Lexington does not have much in the way of liquid assets on their balance sheet, they produce a substantial amount of operating cash flows, to the extent that I do not foresee any major liquidity issues with them.
Yahoo Finance reports that Lexington has 22% inside ownership; however, it is not clear to me if that includes 5%+ owners since there are other REITs that own a stake in Lexington. Even if not major, there have been a few notable insider buys over the past few months.
As far as asset quality goes, my scan of Lexington’s properties leaves me happy with them. It’s also definitely worth noting that while they do have some holdings in Arizona, Las Vegas, and Florida, they are not overly exposed to any problem areas. Many, if not most, of their holdings are in medium-sized cities and not in the major bubble areas. For all these reasons, Lexington caught my eye as a potential buy in the REIT sector.
Lexington owns 225 consolidated real estate assets in 41 different states, plus the Netherlands. They own a well diversified portfolio of commercial, office, and industrial properties. p... also holds investments in loan assets and debt securities through a 50% ownership interest in Lex-Win Concord LLC.
I have actually encountered Lex-Win Concord before when examining Winthrop Realty Trust. Winthrop has taken substantial impairment charges relating to this venture. However, it’s important to keep things in context: Lexington and Winthrop both have already taken balance sheet hits as a result of this venture and Lexington’s total equity “Investment in Non-Consolidated Entities” only comprises 3.1% of its total balance sheet assets. Given this, even if the investment eventually had to be written down to $0, this would not necessarily mean that Lexington is a bad purchase.
My most major concern when examining the holdings of REITs is trying to find ways that balance sheet numbers might be inflated due to the bursting of the real estate bubble. In order to adjust book numbers, I like to examine the portfolio of properties. As it would be ridiculously time consuming to investigate every single property and try to ascertain a value, I scan through their holdings and look for two primary factors: (a) location of properties and (b) date acquired.
The former is important because properties in areas such as New York City, NY and Los Angeles, CA are much more likely to have inflated book values than properties in areas like Johnson City, TN or Salt Lake City, UT. The latter is important because properties with later acquisition dates are much more likely to be overstated on a balance sheet, while properties with earlier acquisition dates are more likely to be understated.
Most of Lexington’s holdings appear relatively safe to me and they own a lot of properties in medium-sized Southern and Midwestern cities where property values never became out-of-control. H... I did find some properties in some potential problem areas, including:
(1) Phoenix, AZ and Tempe, AZ
(2) Florida (Boca Raton, Fort Meyers, Lake Mary, Orlando, Palm Beach Gardens)
(3) Baltimore, MD
(4) Herndon, VA
(5) North Myrtle Beach, SC
(6) San Diego, CA
(7) Michigan (industrial properties)
(8) Suwannee, GA
(9) Los Angeles, CA
(10) Bay Area/Silicon Valley Holdings (Palo Alto, San Francisco)
That might seem like a sizable number of potentially problematic properties, but these holdings actually comprise a minority of their portfolio (probably in the range of 10% - 20%). It is worth noting that while these areas have and/or could experience major hits, some of these areas probably have a good outlook moving forward. I particularly like Baltimore property right now as I believe Baltimore is the type of city that will benefit from rising commodity prices due to its dense urban core.
From my quick scan, property locations are not a major concern to me. The more troubling issue to me is that 80%+ of their properties appear to have been acquired after 2004 and a majority of their properties were acquired in 2006 and 2007; the two years I dread seeing the most!
In his article, Dan Wieman concludes that Lexington’s properties are probably slightly undervalued on the balance sheet. He points out the gains they have made on some of their recent sales as evidence for this. While I can see how he might be right on this issue, I’m very skeptical on this and prefer to play things a bit on the conservative side, so I believe a small write-down (10% - 15%) might be in order.
It’s also worth noting that Lexington does have a few “risky tenants” including Dana Corporation, Tower Automotive, K-Mart, Bally’s Total Fitness (currently in Chapter 11), Tenneco Automotive, Chrysler, and potentially Nextel. Mind you, this is not based on a thorough investigation of the individual situations at each of these properties; these are simple casual observations about potential vacancies based on business prospects of individual tenants. Addition... about 6% of Lexington’s properties are vacant right now and management suggested in the most recent earnings call that this figure could rise to 8% by year end. Once again, however, I will state that these potentially problematic situations appear to make up a small minority in their overall portfolio.
Sample of Properties
One thing I always like to do is see some sample properties for the REITs I analyze. For those familiar with Google Maps, here are links to ten sample properties that you can examine via Google Street View. Note that you might have to look across the street to find the proper building for some of these links, as it is difficult to tell which side of the street is odd and which is even. Also note that my selection is biased in favor of urban properties because they are much easier to find and view via Google Street View. Without further adieu, here’s your selection of sample properties:
Now, onto the financials!
When analyzing the balance sheet, my instinct is to find every single way I can discount the equity account for a company. For Lexington, the most obvious item I find is intangible assets. In their most recent 10-K, LXP’s intangible assets account consisted of lease origination costs, customer relationships, and above-market rent totaling $323 million. To play things on the conservative side, I write down that entire amount.
I also want to write down Lexington’s investment in non-consolidated entities, as well. While it is possible that these investments have bottomed out, I have enough concerns and do not feel knowledgeable enough about their Lex-Win Concord investment to take this at face value. For my purposes, I will discount the entire $125 million.
Finally, Lexington’s $3.3 billion net real estate account should be discounted as well given my fears that some of their properties might be overvalued. While I think a 10% discount is in order, I like to conduct my own “stress test” (so to speak) in order to see how further declines in property values might weaken their balance sheet. LXP’s book value is $13.21 per share with no discounts.
The chart below shows how Lexington’s book value would be impacted by certain write-downs. ... #2 shows LXP with a discount for intangible assets only. Row #3 discounts intangibles plus investments in non-consolidated entities (e.g. Lex-Win Concord). All the rows are cumulative after that. For instance, Row #4 shows the discounts from Row #3, plus a 5% write-down in Lexington’s real estate properties. Row #5 shows my most probable results based on my own assessment:
|Impairment||Impairment Charge||Adjusted Equity||Adjusted BV|
|IA + Concord||448.00||886.00||8.77|
My preferred discount method gives us a value of $5.75, which is about a 38% premium over the stock price at the close of the day on Wednesday ($4.16). I consider the 15% discount a good option, as well, for valuation purposes since it is a bit more on the conservative side.
Earnings, Cash Flows, and FFOs
I typically like to compile a chart that shows earnings, cash flows, and FFOs for several years based on the current number of shares outstanding. You can see my attempt to do so below:
|Q1 - 2009||Annualized||2008||2007||2006||Avr|
|INCR in SE||-0.73||-2.92||4.55||-1.81||2.29||1.68|
Here's a quick guide to my abbreviations:
- EPS = Earnings Per Share
- CFOs = Cash Flows from Operations
- FCFs = Free Cash Flows
- FFOs = Funds from Operations
- INCR in SE = Increase in Stockholders' Equity
Unfortunately, the data in the chart does not seem to be all that incredibly meaningful. Part of the problem is that data for FFOs seem inconsistent and difficult to obtain for Lexington. I could not find a chart in their financial statements laying FFOs out plainly. Instead, I have to rely on scattered press releases and info from the corporate website. LXP's cash flows are also all over the place,so that makes it a difficult measure to ascertain, as well.
The fact that Lexington reported negative FFOs of $0.17 per share for the most recent quarter looks bad, but once you discount one-time impairment losses, things radically improve to 38 cents per share. On an annualized basis, that would equal $1.52 per share. That’s one starting point to determining FFOs for our own valuation.
Another way to analyze this would be to take Lexington’s current income statement and chop off a chunk of revenues; then take that discount to find adjusted FFOs. For this exercise, I decided to chop 10% off of Lexington’s FY 2008 revenues. FY ’08 revenues were $396.5 million, so let’s say a $40 million discount is in order. Let’s throw another $10 million on there just for fun. Using this discount, I come up with FFOs of $1.36 per share. If we go further and discount by 25% of revenues ($100 million total), I still come up with FFOs of 91 cents per share.
One final method to try to determine FFOs going forward is to simply take it straight from the horse’s mouth! Lexington's guidance for FFOs in FY ’09 is in the range of $1.30 - $1.37 per diluted share. ... to be on the safe side, we could discount that down further in some of our valuation scenarios.
One of the most interesting trends of the current economic environment popped up during Lexington’s 4th Quarter earnings call. CEO Will Elgin states:
“Given the returns available under current market conditions, we can earn substantially more by repurchasing our own debt than we can by holding on to [our] real estate assets.”
That should be the quote of the year in my view. Lexington has been selling off properties and buying back its own debt to increase its earnings. This is a bullish signal to me. If a company is wiping out its own debt at huge discounts, that would suggest to me that securities related to the company are mispriced.
It’s also intriguing that Lexington has been able to recognize gains on most of their property sales. This is likewise a good sign and might indicate their portfolio is in relatively good shape. All the same, I don’t want to get carried away and *assume* appreciations of value. I’d still rather assume that their properties get marked down a little bit just to be on the safe side. With that said, let’s move onto some valuation scenarios.
In order to gage a valuation range for Lexington, I’ve decided to run a few scenarios. The goal of this exercise is not to dogmatically nail down a value and assert that it absolutely must be correct. Rather, the goal is to get a range of outcomes and see how they should affect the underlying price for the stock.
For all scenarios, I have assigned a Year 1 FFOs/”added value” figure and I assume a growth rate of 3%. While Lexington’s cost of capital have traditionally been low when it comes to debt, I’ve decided to use a 10% cost of capital unless otherwise noted. “Adj... BV” is the term I use to note the underlying value of Lexington’s equity interest in their assets.
The scenarios are as follows:
Scenario #1: Moderately Conservative
Scenario #1: Moderately Conservative
Y1 FFOs = $1.00
Adjusted BV= $4.23 (which assumes a 15% write-down in RE assets)
Scenario #2: Real Estate Prices Fall Further, FFOs Hold Up Reasonably Well
Y1 FFOs= $1.20
Adjusted BV = $1.21 (which assumes a 25% write-down in RE assets)
COC = 12%
Scenario #3: Disaster
Y1 FFOs = $0.30
Adjusted BV =$-0.30
COC = 13%
Scenario #4: Close to Disaster
Y1 FFOs = $0.60
Adjusted BV = $1.00
COC = 13%
Scenario #5: Neutral to Mildly Conservative
Y1 FFOs = $1.15
Adjusted BV = $5.75
Scenario #6: Equity Jumps, FFOs reasonable
Y1 FFOs = $1.00
Adjusted BV = $10
Scenario #7: Everything Stays the Same
Y1 FFOs = $1.30
Adjusted BV = $5.75
Scenario #8: The Optimist
Y1 FFOs = $1.35
Y4 FFOs = $1.60
Y7 FFOs = $1.90
Adjusted BV = $10
COC = 9%
The results to my valuations are below:
I have examined several REITs and have never had valuations come so far from the actual stock price as I have with Lexington. This is a company where my valuation is so different from the market’s, that I’m left scratching my head; am I really that off or is the market really that off?
It would appear to me that Mr. Market is pricing Lexington for a near-disaster scenario. My greatest fear with LXP is that their RE assets are significantly overvalued, but given the geographic concentrations of their properties, it’s difficult for me to imagine them being more than 20% - 30% overvalued. Scenario #3 assumed they were 30% overvalued on the balance sheet and that revenues plunge --- yet, I still came up with a positive valuation of $2.69 per share. While that is lower than the current price, this is nevertheless a good sign to me.
My “Disaster Scenario” seemed a bit over-the-top to me, but my “Near Disaster Scenario” seemed a slight bit more reasonable. All the same, I still come up with a valuation at $6.98, which is substantially higher than the current stock price. The market might be anticipating that vacancy rates become so high that Lexington moves into negative FFOs, but I’m not sure that I would expect things to turn that bad for LXP. If they can hold up relatively intact through FY ’09, I’m not sure that I would expect things to get too much terribly worse.
The market does not seem to consider the fact that LXP is wiping out debt fairly easily right now. Perhaps the market views the fact that LXP is selling off its properties as a bad sign, but I see it as a brilliant business move. To me, it shows that Lexington’s management is making some smart moves through this crisis. If you can wipe out debt at a discount while unloading some of your (less desirable?) properties, then what’s the issue? The market might also be frightened off by Lexington’s impairment charges, particularly relating to Lex-Win Concord, but you can only impair an asset to $0.
From my analysis, I would conclude that Lexington should be valued at $15. This is based on Scenario #5, plus a significant discount for uncertainty. Down... probable valuation is $8. This is based on Scenario #4 and a slight bump in share price, as I believe Scenario #4 to be unlikely. Upside probable valuation is $35. This based on Scenario #7.
Downside risk is $0. While I believe that bankruptcy is highly unlikely for Lexington, I’ll consider the possibility that their vacancy rates become very high and they become significantly cash flow negative; this would also likely cause a huge drop in commercial RE prices.
Upside potential is $45. This is based on the assumption that the market is very, very wrong on LXP right now and management is able to minimize damage, increase value to shareholders by taking advantage of opportunities, and can eventually increase FFOs.
I initiated a position in this a week or two ago at $4.00. It is a good buy for a large number of portfolios. For those seeking large gains, the potential is there. For those who want a steady dividend, this is a good candidate at 72 cents per share (that appears lower than usual due to the economic crisis). This is a strong buy to me and if you are looking to jump in on a REIT, I believe this is definitely one of the best bets in the market.
Disclosure: Author is long on LXP and FUR.