In the real estate apocalypse, I admit that I am an avid buyer. The naysayers have proclaimed that commercial real estate is the next shoe to fall. It may surprise you to learn that I don’t disagree with that hypothesis. In fact, I believe that commercial real estate will suffer over the next few years and residential real estate still has further to drop.
However, I would suggest that many stocks in the sector already are priced for a disaster of epic proportions and many high quality REITs have been overly punished due to the excesses of their peers.
Due to this, I have been searching for bargains among REITs. I want to find quality REITs that offer favorable risk-reward propositions.
This is Part VII in my unofficially titled “Quest for REIT Value” series and this episode focuses on commercial REIT, Brandywine Realty Trust (NYSE:BDN). Here is a rundown of the previous six escapades:
In my previous articles, I have mentioned several factors I initially search for when examining REITs. My list has evolved a bit since my first articles, but here’s the general rundown of what I am looking for:
(1) Relatively low leverage
(2) Insider buying and a substantial amount of inside ownership
(3) High levels of liquidity
(4) Property in markets near a bottom, with no excessive exposure to “bubble markets”
(5) Strong asset quality in real estate holdings and other balance sheet accounts
(6) Focus on residential RE over commercial RE
(7) Office and industrial RE over retail RE
There is probably no REIT in the market that satisfies all my prongs, but the more, the merrier. Brandywine qualifies under several of these factors:
(1) With a 63.3% Liability/Value ratio, BDN has relatively low leverage for a REIT
(2) BDN has a substantial number of insider buys; however, inside ownership is only 2%.
(4) BDN has many properties in markets near a bottom (based on my macroeconomic view) and is arguably not overly exposed to “bubble markets” despite some major holdings in DC and California.
(5) BDN appears to have strong asset quality from my view
(7) BDN focuses primarily on office properties
Overview and California Holdings
Brandywine leases, develops, and operates office and industrial properties in six primary markets across the United States. Their focus is geared towards office properties, with a total of 214 properties in their portfolio. They also own 22 industrial facilities and a mixed-use property. Their six markets in order of highest concentration to lowest are:
(2) DC Metro
(3) New Jersey/Delaware
(5) Austin, TX
During Brandywine’s most recent earnings call, they stated intentions of pulling out of the Southern California market over time. BDN’s California holdings are minor compared to their other holdings and comprise roughly 4% - 5% of their total portfolio holdings.
All the same, given the fact that Southern California and the Bay Area/Silicon Valley markets are amongst my five riskiest markets, this is good news to me. As most of their California holdings were acquired in 2006 or 2007, I am going to estimate that those properties are 20% - 30% overvalued on the balance sheet.
Washington, DC Segment
The most major area of concern for me is Brandywine’s holdings in the Washington, DC metro area. Fortunately, due to my strategic location two buildings away from two major Brandywine properties, I can verify that they own some nice looking properties. Unfor... they were probably overpriced nice-looking properties when they acquired them.
Almost all of Brandywine’s DC area holdings were acquired in 2006 and have 40+ year depreciation schedules, which means the odds of any of these properties not being overstated on the balance sheet is somewhat slim. Their DC holdings are concentrated in the Northern Virginia suburbs of Herndon, Falls Church, Vienna, McLean, and Fairfax. They also have major holdings on the Maryland side of the metro area in Bethesda and Beltsville. My estimation is that these properties deserve at least a 15% - 30% write down on average.
Fortunately, things look better after examining the two potential problem markets of DC and CA. Most of Brandywine’s Pennsylvania properties are concentrated in the Philadelphia market, with substantial holdings in Radnor, Exton, Newtown Square, and my favorite, King of Prussia! (Bet your town doesn’t have that awesome of a name!)
All of these cities could be classified as outer suburbs which gives me some pause, as I believe suburban prices will continue to experience more pressure in the coming decades. At the same time, most of these properties were acquired from 1997 to 2004 and have accumulated a decent amount of depreciation. Even most of the 2004 acquisitions have accumulated depreciation totals more than 10% of the total gross carrying amount. That should provide some cushion.
Based on my lookthrough, I would suggest writing up BDN’s Pennsylvania holdings by 5% - 10%.
New Jersey/Delaware Segment
Unfortunately, the NJ/DE segment is not quite as easy to tackle as the PA segment. It appears some of BDN’s NJ holdings are actually in the Philadelphia metro area. Meanwhile, they have substantial holdings in the Trenton, NJ metro and the Newark, DE metro. I have more concerns about the suburban Philadelphia holdings than the others.
Once again, however, BDN is helped by the fact that most of their holdings in this segment were acquired from 1997 to 2003. As such, many of these properties have taken depreciation charges anywhere from 15% - 35% of gross carrying value.
Given that, even if property values were to decline very significantly, it’s still somewhat unlikely that the overall holdings in this segment would be overvalued. The NJ/DE segment properties probably deserve at least a 5% - 10% write-up and even that may be a bit on the conservative side.
Richmond, VA and Austin, TX Segments
The Richmond, VA segment is more of a mixed bag than some of the others. It looks like Brandywine acquired the vast majority of their Richmond properties in 1998. Then there are a few properties scattered throughout the ‘00s, before they went on another buying spree in 2007. The ’98 properties still are the predominant group, however, and they have taken roughly 25% worth of depreciation charges relative to the total gross carrying amount.
From my knowledge of the Richmond market, I would not have any major concerns about further substantial price drops. Prices could drop 10% or maybe even 20%, but that should still leave us relatively safe. I also like the Richmond market moving forward more than I do many other markets in America.
Based on this assessment, I would write up Brandywine’s Richmond holdings by 5% - 10%.
Finally, Brandywine purchased a handful of properties in Austin, TX in 2006. While my direct knowledge of the Austin market is minimal, a quick glance at Craig’s List suggests to me that Austin properties did not become too terribly inflated in value. Depreciations charge average around 10% of total carrying values, so I believe a 5% - 10% write-down is in order. However, based on my faint knowledge of Austin, I do like it moving forward.
Now it’s time for a random sampling of properties via Google Street View:
4364 South Alston Ave, Durham, NC (lumped in with the Richmond segment)
Rather than divide things up, I decided to throw all my charts into one section this time. The first chart is my attempt to evaluate how much I should write down or write up Brandywine’s net real estate investments. This is not completely scientific since I based my figures on square footage as opposed to value (that was the best I could do given info I found) and my estimations in the above sections are nothing more than … well … estimations:
Impairment Stress Test
This chart is an impairment “stress test” so to speak. I wrote down intangible assets to $0 for all of these entries and the percentages indicate amount to be written down (positive) or up (negative) for BDN's net RE assets and how that would affect the adjusted book value of Brandywine’s equity:
I also decided to try to estimate whether or not Brandywine's net real estate investments should be written up or down. This chart is based on some of my projections above and the conclusion is in the bottom left corner:
So, my projection is that Brandywine's net RE assets are close to being properly stated, with a possible need for a minor write-down.
Earnings, FFOs, Etc.
This chart measures several earnings and cash flow variations over the past three years in per share figures. The chart below measures the most recent quarter compared to the same quarter in FY ’08. Note that all these numbers are approximations and some figures might be off a bit; additionally, I tend to assume more dilution when calculating these numbers:
Here's an index just in case you need to know what any of the abbreviations mean:
DEPS = Diluted Earnings Per Share
CFOs = Cash Flows from Operations
FCFs = Free Cash Flows
FFOs = Funds from Operations
AFFOs = Adjusted Funds for Operations
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
INCR in SE = Increase in Stockholders' Equity
Dividends = Dividends paid out on a yearly basis
Additionally, we should note that Brandywine’s FY 2009 guidance for FFOs was in the range of $2.04 to $2.21.
Revenue Stress Test
As many market prognosticators are predicting a commercial real estate meltdown, I thought it might be useful to conduct a revenue stress test on Brandywine. I decided to try two different methods. For the first table, I look at declines in total revenues (with FY ’08 as my base year) and how these declines would affect Funds From Operations. However, it should be noted that these figures are probably not realistic due to the fact that I am completely ignoring the expense side:
For the second table, I run another revenue stress test, but this time I try to project a decline in expenses that would probably result from a revenue fall as BDN looked to cut costs. Brandywine has a 22% operating margin for FY ’08, so I project increasingly larger declines in that margin as they take a larger revenue hit:
Now for the valuation scenarios! For all these scenarios, I am inputting an initial free cash flow/”added value” figure for Year 1 and then assuming a 3% constant growth rate. I tend to play things on the conservative side with costs of capital:
Think of the above valuation chart more as a table of possibilities. I arranged them from the most conservative scenarios to the most aggressive.
Brandywine is currently selling under $7 and dipped below $3 at one point back in March. Even during its 2007 highs, it appears not to have sold much higher than $35. I’m left scratching my head once again, as my valuation appears to come miles away from Mr. Market’s even when factoring in a great deal of carnage.
My probable valuation for Brandywine is $23, which factors in a 20% property portfolio drop (from book value) and a 30% drop in revenues. To be further on the safe side, I’d discount to $18. My downside probable valuation is $13. My upside probable valuation is $36. It would appear that even assuming some extreme carnage, Brandywine’s liquidation value would be at least $4.
For a downside risk, I don’t know what to say, so I’ll go ahead and say $0. This seems extremely unlikely to me given my “liquidation value” above, but in the event that Brandywine could not stay liquid enough to pay its bills and BDN’s property portfolio was more than 35% overvalued on its books, this could happen. More realistically speaking, March’s low around $2.50 might be a downside risk.
Upside potential is $50. I get the feeling this is the most controversial aspect of my report since it traded at around the $35 level in 2007. However, I’m having difficulty explaining this except to suggest that the market appears to have taken the value of their property portfolio at face value.
The reason I argue this is because I have now examined several REITs and my upside potential almost always matched the stock’s top price during the bubble. However, there is one big difference between Brandywine and a lot of the other REITs I have looked at --- a very substantial chunk of BDN’s properties were purchased pre-2000. That means not only are the book values not inflated, they are probably significantly understated when you take into account rising property values and accumulated depreciation on BDN’s balance sheet.
While I am a bit leery of buying into the market right now after we’ve had such a spectacular run-up, I still believe the Brandywine is a good buy under $7. I have initiated a long position on the stock. If the market drops further and BDN retraces back to the $5 level, I will probably double-up my investment.
My biggest fear with Brandywine would be their liquidity. I’d like to see them sell off more properties and build up a larger cash position. Of course, this is a difficult market to sell in. I’d also like to see them lower their debt levels slightly if they can do so at a discount like many other REITs have been doing.
Even with the negatives, Brandywine looks like a good buy for the long-term income investor. It pays a reasonable dividend and looks significantly undervalued. Assuming the $1.76 per share dividend could hold up, the stock would have a 3.8 Dividend/Price ratio. However, I wouldn’t assume the dividend will stay that high. I expect it to drop a bit.
Disclosure: Long on FUR, LXP, BDN