It seems that shares of Rouse Properties (a spin-off of GGP) are trading cheap on the when-issued market at the current price around $11.50. As is often the case, it's not possible to put an exact value on what it is worth but, at $11.50, you can conclude that it's actual worth is somewhat more than the current asking price ($408mm market cap). This conclusion is supported by indications from a cash flow-based valuation, estimated liquidation value, recent debt refinancing, and an equity backstop arrangement with a reputable investor Brookfield Asset Management (NYSE:BAM).
How RSE Came To Be:
Rouse properties is a REIT (technically speaking, it will be a REIT once they make the appropriate tax election) composed of 30 Tier-B regional malls. These malls were originally owned by General Growth Properties which went through bankruptcy during the credit crisis, and emerged with new owners including Brookfield Asset Management, Pershing Square (run by Bill Ackman), and Fairholme (run by Bruce Berkowitz). As a part of the post-bankruptcy plan, the new owners arranged for GGP to spin off non-core operations through new companies Howard Hughes Company (which is an interesting investment case in its own right) and Rouse Properties.
As has been shown many times, spin-offs can create excellent opportunities for those who pay attention. The shareholders receiving the stock in the smaller spun-off company generally tend to sell the stock rather quickly creating downward price pressure. That applies to most spinoffs. Furthermore, unlike most spin-offs, this one is taxable, meaning that holders of GGP wishing to retain RSE stock will need to use other sources of cash to pay the tax. Would they rather come up with the extra cash to send the government and hold on to this collection of Tier-B properties or would they rather sell the stock and pay the tax from the sale proceeds? I suspect most GGP holders chose/will choose the latter.
Additionally, two further factors help us. The stock is presently trading on a when-issued basis, which is a market with very thin volumes. Secondly, when I began purchasing the stock, it was the day before New Year's Eve. That time of the year, volumes are extremely light. So the stock which was issued at 14 quickly dropped to around 11.
Tier-B mall properties are not the most attractive assets, particularly in the midst of a sideways economy. Aside from buying them a low price, proper management is key to maintaining and hopefully generating value. Here, after the spin-off and the rights offering, Brookfield Asset Management will be a very significant owner of the properties (currently 37%). Brookfield has an outstanding track record of operating real estate properties profitably and making good capital allocations. Thus, even though the properties are not top-class, some comfort can be had in the fact that Brookfield has a major vested interest in them.
Furthermore, the CEO Andrew Silberfein will receive $10 million of options and a $1.2 million annual bonus (cash or stock at his choosing) aside from a cash base salary. Generally, in spin-offs, the management benefits by having the options struck at a low strike-price which persists in a spin-off as detailed above. So the intentions of insiders are to be closely monitored. While Andrew won't grow poor in this position should the company not improve, he clearly stands to gain handsomely if it does. Joel Greenblatt will tell you all about this in his book "You Can Be A Stock Market Genius". Another "insider" is Brookfield which also has a vested interest which I will detail below.
The multiple approaches to valuing RSE vary in their accuracy and reliability. Let's start with the more reliable ones first and move toward to less concrete ones later.
As with smaller spin-offs, information on RSE is thin, going back only a few years. The recent bankruptcy also renders this data, particularly in 2009/2010, more unreliable for projections as the properties weren't operated with quite the same focus as they would be without having to deal with a Chapter 11 proceeding. Thus, we turn to insider Brookfield to give us a signal through their backstop of the upcoming rights offering. RSE states their intention to pursue a rights offering shortly after the spin, raising $200mm for investment into the properties (as you can imagine, in a company nearing/in bankruptcy, discretionary cap ex is unavailable, especially for the lowest-tier assets). The rights offering has "over-subscription privileges" feature by which shareholders who do not exercise or sell their allotted rights will automatically surrender those rights to other shareholders that wish to subscribe in excess of their original allotment at no cost to the receiving shareholders. Through this over-subscription, subscribing shareholders can increase their ownership proportion at a below-market price at the expense of the non-participating shareholders.
As of this writing, the rights are set to be offered with an exercise price of $15 (this may change given the current trading price of RSE). BAM has agreed to subscribe for its entire share of rights and participate in any over-subscription required for RSE to raise the full $200mm required. Furthermore, BAM's backstop is contractually set assuming an exercise price of $15/share. While this price may change given the current price of RSE, the fact that BAM is willing to increase its ownership from 37% to 54% at $15/share sends a strong signal to the outsiders. Given how successfully BAM has allocated capital in the past and their familiarity with value/earnings of these particular mall assets (from being a majority owner of GGP), once can feel pretty secure buying at $11.50 what Brookfield is willing to buy at $15.
Let's move to the second reason I concluded these might be cheap. In the filing, it can be seen that RSE will borrow $435mm (Term Loan) and $50mm (Revolving Line, funded $20mm at separation). The loan is being made by Wells Fargo and U.S. Bank on a pool of 17 properties. These are two of the strongest banks in the country, which provides us some assurance over the quality of those 17 properties as both WFC and USB have historically been known for high asset quality. Additionally, a covenant for loan funding is that the LTV can be at most 65%. Suppose, then, that the banks funded the loan at an LTV of 60%. We get total asset value of about $755mm, which implies an equity value of $300mm on those 17 properties alone. Since most of GGP's properties had their financing issues resolved during the bankruptcy, it isn't far-fetched to assume that the other 13 properties also have positive equity of a decent amount. Given that these 13 carry a total mortgage balance of $724mm at a reasonable rate (5.33%), even a 75% (assumption) LTV agreed to during the bankruptcy, would generate an equity value of $241mm. Since the credit crisis, banks have been very conservative and I believe these calculations, therefore, aren't too optimistic.
Of course, a more traditional REIT valuation based on FFO can be used to validate the purchase. There aren't many pure regional mall REITs out there and the closest comps are CBL, PEI, and GRT. For the reasons of brevity, I won't put all the calculations here. The average Price/Adjusted FFO of these three and of other REITs is close to 10x (FFO being adjusted for impairment, reorganization, and above/below-market and straight line rent amortization). RSE is trading between 6x and 7x, depending on how you make the adjustments. If you prefer to calculate equity value using the more conventional cap-rate method, you'd calculate the NOI and then divide it by the cap-rate. After that you'd subtract the preferred, debt, and non-controlling interests to get the equity value. Using this technique in reverse results in implied cap rates of between 6%-9% on the three comparable REITs and 10.25% on RSE. Another way to use the accounting numbers is to look at the book value which is around $400mm. Due to GGP's bankruptcy, the book value of its assets was stated at fair value in accordance with accounting rules. Generally in bankruptcies, the asset fair value is conservatively stated in order to allow future operating flexibility. All of the goodwill was written off. The book value represents purely the assets value and the operations since the reorganization. So buying close to book value can provide some downside protection.
The fourth and least reliable way to assess undervaluation is based on recent sales of some of the worst malls in the country at around $215 per square foot. Now, note that this number reflects sales of individual assets - not portfolios - and therefore we should discount it to reflect the challenges of selling a portfolio of assets. As a proxy, we can look at the implied square-foot price for the comps (based on their trading equity value and debt) and see what happens if we apply that price to RSE. This average calculated value for the comps is around $115/sq. ft. whereas for RSE, it is $75/sq. ft. If we apply $115 to RSE, we'll get 21mm sq.ft * $115 = $2.415bn. From this, we subtract the pro-forma indebtedness of $1.2 bn to get an equity value of $1.2bn. Even if we apply a safer, $100 square-foot price, we get an equity value of $900 mm, which is well in excess of the $400mm market cap. On the existing share base, this valuation implies a per-share price of $25. As a very quick and conservative evaluation of the potential dilution of the rights offering, suppose that rights are offered at $11.50, and I do not exercise my rights. Further suppose that the $200mm raised adds zero value to the portfolio or company. Under this dire scenario, the per share value falls to $18.
Potential upside from valuation:
Some of this undervaluation is, of course, deserved as the RSE malls have suffered throughout GGP's bankruptcy. Very minimal capital expenditures were made on these malls as can be seen from the filing. The sales/sq.ft now run at about $281 with an occupancy of 88%. The averages for the competitors are $300-$350 and 91-92%. In the real-estate industry, $250/sq.ft. is the level below which a property is at the risk of failure. So, there are downsides here to be sure. But the potential upside, in my view, outweighs the downsides given a combination of the above factors.
As BAM controls and a BAM-appointed nominee runs these malls, they may be able to bring these numbers up a bit. However, I'm not counting on it. Even using the present numbers which are below industry averages, a discount of at least 33-50% seems enough to warrant a position in my portfolio. The 33% number comes from the rights-offering price and the 50% is an average of the last two valuation techniques mentioned above (which, to reiterate, are very general).Additional disclosure: I am long RSEw, RSE-WI (which is the when-issued version of RSE, i.e. Rouse Properties, Inc.)
Disclosure: I am long RSE.