Forest City Trading at NAV

Dec.18.06 | About: Forest City (FCE.A)

Forest City (NYSE:FCE.A) is an $8 billion (asset) real estate operating company that operates through three business divisions — commercial, residential, and land development. The company is not traditional in the sense that it is one of the few publicly traded real estate companies that does not have REIT status.

This may seem like a tax disadvantage, but it actually confers a competitive advantage since their large depreciation charges result in low tax payments anyway and because it enables the company to reinvest its free cash flow into the business (whereas REITs are required by law to distribute 90% of their income to shareholders).

The company has several other competitive advantages, most notably its extraordinarily low cost of the mortgage debt they primarily use to finance their properties. With largely fixed-rate, nonrecourse mortgages with a weighted average rate of around 6.1%, the company isolates risk almost entirely at the property level while leaving open the possibility of refinancing when advantageous. Most importantly they have a consistent and illustrious track record of maintaining what every real estate company aims for, that is a wide, positive spread between cash returns and the cost of producing that cash.

The most important valuation metric for the company is an accurate calculation of Net Asset Value. Clearly, taking stated Shareholders Equity is a naive way to do this. Forest City has (obviously) real estate listed as its big asset, which means that values are listed on their balance sheet at cost. With the weighted average square foot of all their properties purchased around 1997 prices as per my calculation, there will clearly be a significant downward bias in stated NAV. We have several options for adjusting it.

First, we can try to estimate NAV on a “fair value” and comparable property sales basis. This would require something like figuring out a value per square foot for each property owned based on similar property sales by the company or another investor. This is probably overly ambitious since the data is not terribly robust and the company owns hundreds of properties, meaning that guesswork will be a big part of the valuation. Nonetheless, I’ve attempted such a valuation using comparable sales data from a large consulting firm, and arrived at an NAV of around $48/share.

Second, and more reasonably, we can use the valuation metric that commercial real estate professionals themselves use when valuing properties. Analogous to a DCF, the “capitalizing net operating income” method takes earnings before interest, deferred taxes, depreciation, amortization, etc. and discounts the figure at an appropriate rate based on the firms cost of capital and the anticipated growth rate of NOI. With NOI around $540million for their two largest divisions (combined), a cost of capital around 6%, an anticipated continuing growth rate of 1.5%, and liabilities of $7 billion, we reach a net asset value of [540/(.06-.015)] - $7,000 = $5 billion.

The firm has a bit less than $1 billion in other net assets from the land development group, which we can add on to reach a total firm valuation of $6 billion, just around its current market cap.

For those seeking safety and small upside potential, I feel the stock is safe given its financing strategy, diversified real estate portfolio, and strong, shareholder friendly management. Those who have held through the last few years have done quite well, but there is no substantial discount in FCE and further big advances are unlikely.

Nonetheless, it’s a great company to have on the radar screen in the event of price declines opening the door for buying opportunities.

FCEA 3-yr chart: