Since worries about the European debt crisis, a double dip recession, and future guidance of companies sent the Dow and S&P down nearly 20% from their April highs, First Industrial’s (NYSE:FR) stock has been cut in half ($9.33 at April peak, $4.04 now). First Industrial is trading at less than 5x 2010 earnings [.90 FFO] with a price to book ratio of .38—either the market is pricing in a type of depression downturn for industrial real estate or First Industrial is now at a very attractive value.
Personally, I feel First Industrial is trading at an attractive value for four primary reasons:
- Too much leverage for many institutions to feel comfortable with
- Pays no dividend on common shares
- Operating fundamentals are still decreasing (rental rates & occupancy)
- Some institutions are restricted from owning it (see reasons 1,2,&3 above)
My current investment thesis is that First Industrial will be able to work through these predicaments within the next 12 months, leaving investors a handsome return from its current market price ($4.04). My reasoning relies upon two assumptions:
- The Federal Reserve and economic policymakers ensure we don’t fall into a prolonged period of “debt deflation”
o On the contrary--future inflation could greatly help the equity value of FR.
- Operating fundamentals bottom out by the end of this year (rental rates stabilize and start to increase into 2011 along with occupancy)
o CB Richard Ellis 2010 Industrial RE Research Report forecasted this.
I concede that growth prospects for First Industrial at this moment don’t look great, but as a student of Benjamin Graham (Buffett’s mentor), my take on investing has much less to do with what type of “growth” or “great” business I buy as much as it has to do with the price I pay for that business. I simply believe that the market has over-discounted First Industrial’s stock price into an artificially depressed state because it is in an industry (commercial real estate) in turmoil.
I estimate First Industrial’s free cash flow this year (2010) to the common around $65 million for which the market has now priced the value around $250 million, or just over 4 times free cash flow. Historically, FR has traded near 11x free cash flow. This is what I mean when I say the market has “over-discounted” First Industrial’s share price. I believe this situation fits the bill of Graham’s idea of investing in severely discounted companies in industries out of favor with the times.
First Industrial is one of the few REITs post-financial crisis that is still trading well below its book value (P/B ratio = .38). I find the book value of REITs to be an excellent starting point when trying to gauge the value of a REIT’s assets and subsequently a fair value for the stock price. The book value of a REIT is found by subtracting depreciation from the historical cost of “building” assets on a REIT’s balance sheet (since land is not depreciable), plus any other assets, minus total liabilities.
Many investors argue that book value is of no use when analyzing a REIT’s market value because by definition it is not a “fair market” value. While this assertion “face value” is correct, many overlook the fact that book value gives an investor a good insight into historical asset market prices (or what a REIT paid for its assets). From there investors can use third party research regarding the specific type of assets the REIT holds to extrapolate asset values into the present.
Anybody who repudiates that book value holds relevancy when analyzing a REIT’s assets should consider that Bill Ackman (Pershing Square Capital Management) used book value as the start of his analysis on General Growth Properties. Ackman stated that “General Growth is worth at least book value” while it was trading under $1 last summer; he made a 3,000% return on that investment. While the relative importance of book value can be debated, there is strong empirical evidence for using book value as a relevant factor when determining fair value.
The fact that First Industrial is trading at such a discount to book value can be partly explained by occupancy weakness (81%), declining rental rates for its portfolio, and excessive leverage which has hurt cash flow. Looking past those variables, First Industrial appears to be a good value for investors willing to wait for operating fundamentals to rebound (occupancy and rental rates to increase) while First Industrial de-levers.
Below is a break-down of First Industrial’s balance sheet, capitalization structure, and book and market values of equity. Its book value currently ($11.40) stands 165% higher than market value ($4.04). Before the financial crisis it was not uncommon to see REITs trading at 2,3, or 4 times book value depending upon the specific REIT and situation. My belief is that the market will again eventually value First Industrial shares above book once operating fundamentals rebound - after all, commercial real estate goes in cycles - and management can bring down net debt/total assets to a more normal ratio of 50% from the current 65% ratio.
A high net debt/total assets ratio is a major reason why First Industrial is not paying a dividend on its common shares as it is close to breaching a loan covenant on its unsecured debt. This is why FR is focused on paying down debt to bring back institutional investors, who demand less leverage. If First Industrial can de-leverage to a more conservative net debt/total assets ratio of 50%, institutions will feel more comfortable owning/buying the stock, which should help increase the share price.
Condensed Balance Sheet (End of Q1 2010):
- Total Assets: $3,086,196
- Total Liabilities: $2,027,923
- Preferred Equity: $275,000
- BV Common Equity: $783,273
- MV Common Equity: $255,000
- Book Value of Common Equity/Share = $11.40
- Current Market Price/Share = $4.04
FR’S Current Capitalization Structure:
Book Value of Preferred Stock
Market Value of Common Equity
Enterprise Value (debt + equity)
I will illustrate my point with two quick and easy valuation metrics that show how First Industrial is trading at a discount to net asset value:
- Projecting cap rates from recent asset sales to whole portfolio’s NOI
- Using gains/losses from recent asset sales on a book value basis to extrapolate a whole portfolio valuation
Note: Statistics taken from First Industrial’s 2010 Q1 supplemental information
In 2009, First Industrial sold 21 properties totaling 1,934,164 square feet for a total $101.5 million. Total asset sales for 2009 equated into an average cap rate of 7.8% and an average price per square foot sold of $51. First Industrial’s total portfolio value can be illustrated by dividing First Industrial’s 2009 net operating income by 2009’s average cap rate of 7.8%.
Portfolio Value (NOI approach)
234,364/.078 = $2,929,550
Portfolio Value (price per square foot)
68,962,777*51 = $3,517,101
A total enterprise value of First Industrial’s portfolio of $2,929,550 equates to a common share price of $9.12. Note that the price of $9.12 a share doesn’t include any value from First Industrial’s 660 undeveloped acres of land on its balance sheet. FR has averaged 300k selling price/acre on undeveloped land the last 18 months
PRICE PER SQUARE FOOT APPROACH:
A total enterprise value of $3,517,101 equates to a common share price of $17.70, assuming First Industrial’s aggregate portfolio could fetch $51 a square foot. At this moment in time I don’t believe First Industrial could sell its whole portfolio for $51 a square foot but I still believe this to be a good illustration of how First Industrial is trading at a good discount to its net asset value—investing is not an exact science.
It is possible the general macro-economy is heading for a period of debt deflation (as Paul Krugman posited in his Op-Ed piece in the New York Times a week ago). Under this scenario, my investment idea would not yield very good results--this scenario is in part what I think the stock price has been reacting to over the past 3 months. In a debt deflation scenario, commercial real estate values would continue to decline in a self-reinforcing downward spiral as tenants would keep prying for rent concessions that owner/operators would be forced to comply with or risk losing occupancy and income (like the situation CRE is in now but for more of a prolonged length of period).
However, I am confident that our economy and markets will eventually prevail. While Europe may hinder their economic growth for years to come with excessive austerity measures (remains to be seen) to save their currency and financial markets, my bet is that US economic policy makers will continue to “throw” more liquidity into the US economic system if economic data continues to be bleak in the back half of 2010. A type of "controlled" inflation I think is the best way out of our current economic situation--asset prices need to start rising to promote investment--even if it means less in "real" dollars. Future inflation would be a BIG help to the future equity value of First Industrial, which is why I like the stock long term from its current valuation.
Disclosure: Author is long FR