When evaluating short plays of financials with falling asset values, a very profitable strategy for me the past two years, I look for three things: ownership of the declining assets, short-term or callable financing, and a high degree of leverage.
In 2007 such companies were easy to find. I shorted Thornburg Mortgage (TMA), where all three of these factors were present to a high degree, in August 2007 when it traded at 23.75. Now the stock is down about 99%, trading at 27 cents. There are still plenty of companies like this with declining assets and high leverage, and at least a modest degree of short-term or callable debt. These companies can still suffer dramatic declines as their leverage means declines in asset values are multiplied several times over. I’ve already written about three of them here on Seeking Alpha, and those who shorted the companies I wrote about have made handsome profits: RWT is down 30%, CRZ is down 29%, and FED is down 40% from the time I submitted my articles. (By the way, I think these stocks will continue their dramatic declines over the next 3-12 months).
Today’s topic is Maguire Properties (MPG), a REIT that owns office properties in Southern California, with its greatest exposure in Orange County, Downtown LA, San Diego County, and elsewhere in Los Angeles County. It meets 2 of my tests with flying colors, with a large amount of leverage and declining asset values. MPG also has a decent amount of debt coming due over the next 11 months, as well as a repurchase agreement (which typically have equity covenants), causing MPG to meet the third test of a good real estate short: unstable financing. More on this last topic below.
Not a Good Time to Be in SoCal Offices
While commercial office real estate prices never rose to quite the irrational highs of the residential market, there nonetheless was massive overbuilding during the 2004-2007 bubble years, and many purchasers vastly overpaid for office properties during this period. No office market became quite so overinflated as the Southern California market, with the epicenter of overbuilding in central Orange County, the home of a huge number of distressed and bankrupt real estate companies. To catch up on current trends, I invite you to read the following articles:
- The OC office tower vacancy rate is 25.1%, up from 18% last year, and new construction and tenant shortages are making things worse, and rents are rapidly falling.
- San Diego office vacancy rate headed toward 16% thanks to new construction and tepid demand.
- San Diego office vacancy spikes to highest level since 1996.
- Businesses take less office space nationwide. (WSJ subscription required for full article)
- US Commercial Property prices fall most since 2000 – Moody’s
- Nationwide office vacancies rose sharply in first quarter, demand negative, negative impact on property values.
- Goldman projects commercial real estate prices to fall 21-26% over two years. (WSJ subscription required for full article)
- Commercial property values in for steep drop says loan liquidator.
MPG’s Office Property Portfolio
Consistent Losses From Operations
MPG purchased the bulk of its real estate portfolio in the bubble years of 2004-2007. Reading the articles above, it is pretty clear these properties are now deeply underwater, especially the OC properties. But you don’t have to take my word for it, just read the company’s latest quarterly report. MPG is very short on ready cash. The company has total liabilities of $5.4 billion, but total unrestricted cash of only $98 million, a ratio of just 1 dollar in unrestricted cash for every 55 dollars in liabilities. (Source) Realizing this, the company is undertaking a fire-sale of its Orange County properties. It has agreed to sell Main Plaza in Orange County for $211 million, a sale for which it recorded a loss of $51.9 million, suggesting a 20% decline in value of this property since it was purchased in April 2007 (Source, p. 2). But wait a minute—if the other properties purchased from Blackstone in the same multi-billion dollar deal are down the same 20% in value, then the company is underwater another $522 million on the properties it still has on its books. Assuming the company has taken $100 million in depreciation for these properties already, that would reduce stated book value per share from the current stated value of +$3.94 per share as of 6/30/08 down to –$4.95 per share, making shares of the stock, already down 75% from their peak in early 2007, nearly worthless. I actually think things are even worse than that. Companies in severe financial distress can’t be choosy about which properties to offload, and it is logical to assume that MPG sold the OC building that it would have had to take the smallest markdown on. Indeed, Main Plaza is one of the larger, nicer, and better located of the OC properties.
Backing up a bit, let’s look at the company’s recent financial performance. MPG suffered negative operating income in calendar years 2005, 2006, 2007, and the first half of 2008. Even in the good years, MPG was losing a lot of money. Reported shareholders’ equity has also been declining steadily since at least December 2004. (Source, see annual data link) The company has also reported losses from continuing operations for each of the past five quarters, and also 5 straight quarters of losses in its unconsolidated joint venture. (Source, p. 11 & 13). Yet another measure of operations, adjusted funds from operations, not only shows losses for each of the past 5 quarters, but also shows the amount of losses has gotten worse each and every quarter. (Id, p. 15).
Crash And Burn
Lots Of Debt Coming Due In Next 11 Months, Even Worse Following Year
Right now MPG, with reported shareholders equity of $188 million and unrestricted cash on hand of $98 million, has $327.365 million of construction loans and $206.75 million in variable rate mortgage loans maturing in the next 11 months. (Source, p. 18-19) Clearly these loans, equal to $534.115 million, cannot be repaid with current funds. They will have to be replaced. But can they?
Lately the FDIC and Federal Reserve have been increasingly proactive at limiting and urging banks to reduce their construction loan exposure. Asset values have decreased.
For some of the loans, MPG indicates that “One one-year extension is available at our option, subject to certain conditions” and for others “Three one-year extensions are available at our option, subject to certain conditions.” Will those conditions be met? The banks will certainly not in this environment renew them if they don’t have to, except on financially ruinous terms (see economic background section above). One possible outcome is the banks consider the terms not met and demand repayment, but MPG does consider the conditions met. Then the issue goes to court and/or arbitration.
Looking at what has happened so far when a large loan matured in April of this year. It doesn’t look good for MPG. In its annual report, it noted that its Griffin Towers loan, then $200 million, that it expected to have to pay down only $20 million in order for it to be renewed as a $180 million loan. In fact, the loan is showing a balance of $125 million, indicating that it had to pay down the loan to a much greater degree than expected ($75 million v. $20 million.) The interest rate on the loan also jumped up substantially following the 4/2008 refinance, from 4.6% to 6.5%. The company then took out a second $20 million loan on the property at an eye-popping interest rate of 13%. And this was in April, market CRE rates have gotten considerably worse since then.
Things start to look even worse once we get into 2010, less than 16 months away. The loans that are subject to one 1-year extensions in late 2008 or 2009 will see those extensions expire in late 2009 or 2010. All the while, even if the current negative trend moderates, huge amounts of cash will be burned through and reported book value will fall below 0. And the fact the company just converted a 4.6% loan to a 6.5% and 13% loan will certainly hurt its burn rate. Construction costs are also rising due to increases in raw materials prices. A crackdown on illegal immigration hurts labor costs, as does California’s increasingly high minimum wage (which also results in higher wages to union members whose wages are contractually tied to the minimum wage).
Common stock is virtually worthless, failure as a going concern likely in 18-36 months
In my section describing the Main Plaza sale, I noted that stated book value if the other properties purchased from Blackstone take the same 20% haircut, then the company has book value of -$4.95 a share.
If anything, that is too generous an estimate. An earlier article on Seeking Alpha about MPG deals with the fact that some of MPG’s older properties may be worth more than reported book value. It provides estimates of MPG’s NAV at various cap rates. CBRE Global Insight lists office cap rates for Q1 2008 at 6.5%. But it then cautions that this is definitely an underestimate of Q1 cap rates, because only the best properties were selling. But taking this 6.5% cap rate, the earlier article suggests this gives MPG a NAV of $17.15/share. Since then the company has reported diluted net losses of $4.30 a share, bringing the article’s estimate of MPG’s book value at a 6.5% cap rate to $12.85/share.
But we KNOW that 6.5% is not a realistic cap rate to value MPG. The weighted average interest rate on MPG’s refinance of its Griffin Towers property, discussed above, was 7.76%. And that was with a huge pay-down of principle. At an 8% cap rate, the NAV estimated by the older SA article was $0.04/share. Subtracting the same $4.30 in reported losses since then brings estimated NAV to -$4.26/share, very close to my quickie book value estimate of -$4.95/share.
However, I think things will get even worse than these current -$4.65-ish/share estimates. First, burn rate is going to go up, not down, as the economy slips into recession. Second, cap rates will likely go even higher than 8%. Rates averaged above 8% for a full decade, between Q2 1992 and Q4 2002. They peaked above 9%. Third, the other part of the equation, rents, are headed down. Next, MPG has a land portfolio. Land that is ready for development can be thought of as an option on the profitability of new construction, and its value can fluctuate wildly, much more than completed properties. Thus MPG’s land portfolio, purchased during the RE bubble, has likely suffered a much worse decline than the 20% decline of Main Plaza.
The value of MPG could easily be -$10/share now and -$20/share in the near future. There is only so long this company will be able to sell off its better properties and rely on its older, now well-below-market loans to continue as a going concern. They will mature, and as the Griffin Towers loan showed, even in April, when the market was better than today, financing is only available to MPG at extremely harsh terms.
Since MPG’s debts exceed the value of its assets, and the company consistently loses money each quarter, the only value of MPG shares are as deeply out-of-the-money call option on Southern California office properties. This option will expire when the company is no longer able to fund its continuous losses from operations, which I estimate at sometime in 2010 or 2011. But CRE is right now headed downhill, and MPG bought most of its portfolio at bubble prices. Worse still, for MPG to recover its former value, price would have to exceed the old bubble prices since the company has lost so many millions from continuing operations since then, and those losses would need to be recouped. I really can’t say exactly how much MPG’s option value is worth, but given that it is the only value in this negative-value, cash-burning machine, today’s stock price of roughly 11.5 simply cannot be justified. A generous option valuation of the MPG’s common stock might be $4 a share now and $2 by mid-2009 (as MPG’s option value declines as the company’s cash crunch worsens). Remember, with a NAV of -$10 to -$20 a share, the company will have to climb out of a huge hole (while overcoming the headwinds of its consistent losses from operations) to even reach $0 value, and then climb even higher. In the epicenter of the real estate bubble as the US economy appears to be headed into an L-shaped recession.
I am not alone in my conclusions about MPG’s extremely poor prospects and doubting its ridiculously over-priced shares. Recent headlines for this stock are:
- Maguire Properties Started At Sell By Oscar Gruss (7/30/08);
- S&P REITERATES SELL OPINION ON SHARES OF MAGUIRE PROPERTIES (7/29/08).
Jaywalk’s analyst round-up shows MPG rated lower than 85.7% of office REITs, lower than 92.7% of financial stocks, and lower than 91.2% of stocks overall. Out of 18 analysts, 1 is “strong buy”, 0 are “buy”, 7 are “hold”, 5 are “sell” and 5 are “strong sell.” You can add me to the strong sell group.
Disclosure: Author is short MPG, TMA, CRZ, RWT, and FED.