- Most REITs remain around March lows despite a recovery of major indices.
- The REIT Colony Capital has struggled with profitability for years and has seen significant impairment losses.
- Colony Capital has rising leverage, high interest expense, and high executive compensation, which have made its cash flow margins quite thin.
- The REIT also has high exposure to the senior living and hotel industries, which are likely to face the brunt of COVID-19-related losses.
- Without significant cost-cutting efforts, it is unclear that the company will see a full recovery.
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The U.S. equity market crash of March 2020 was one of the fastest-paced stock market declines in history. The following rally has been one of the market's most rapid rises. That said, a surprisingly large number of companies and industries have not felt the ongoing rally and remain near March 15th lows. In my opinion, these are the companies investors should be looking at today.
In general, companies that have failed to return fall into two categories: those undervalued and forgotten by the market, and those which carry extreme risk. In general, REITs fall into either of those two categories, as most remain near mid-March lows. Some are likely to see significant COVID-19-related losses, and others are pulled down by investors' latent fear of REITs (stemming from the last financial crisis).
One battered-down REIT is Colony Capital (CLNY), which is one of the largest opportunistic real estate investment companies in the world. Problematically, the company focuses on hospitality and healthcare properties (mainly senior living) which are likely to be hit hard by the current situation.
Colony Capital's Ongoing Difficulties
The company has been struggling for quite some time. The share price has been in a negative trend since 2015, and the company has been unable to turn a profit for years. Its leverage has been on the rise, as have impairment losses from underperforming assets. See its performance as well as dividend yield and P/B below:
As you can see, the total return of CLNY has been deeply negative for quite some time, falling around 66% since inception (with dividends included). While its returns have been abysmal, its valuation is very low today, as it is far below its book value and pays a very high dividend yield. Obviously, if the company can manage a turnaround, it may be very rewarding to investors.
In order to recover, the company is looking to transition into data centers, which may not be as great an investment opportunity as the company believes. See the article "SRVR: Beware The Hidden Risks In 'Technology REITs'" for more information.
Still, digital assets make up a very small portion of Colony's total portfolio today. In 2019, the company saw $6 million in operating property revenue from digital assets and $577 million and $828 million from healthcare and hospitality respectively. Colony also had $444 million in revenue from its various opportunistic debt and equity investments.
Unfortunately, the company's high operational expenses and significant impairment losses have resulted in deeply negative earnings. Its cash flow was positive until Q4 2019, signaling that it is hardly profitable, even adding back impairment losses. See below:
Problematically, Colony's interest expense is high enough that it is difficult for the company to make a profit. After property expenses, it saw $1.2 billion come in last year, $535 million of which was paid out as interest expense. This only leaves $700 million to pay management employees and maintenance capital expenditures on its $20 billion in assets.
The company has $9 billion in debt and pays slightly over a half-billion in interest expense, so it is paying roughly a 6% interest rate on most of its debt. Looking at its last 10-K, we can see this figure ranges from 4-12% depending on the asset and debt subordination. These rates are problematically high because they leave little cash flow left to Colony.
This puts the REIT in a bind. In order to refinance at lower rates, Colony would need to have greater profitability, which it cannot obtain without lowering its interest expense. As you can see below, its total liabilities to assets have been on the rise, as well as its financial debt-to-cash flow:
Clearly, Colony's financial deterioration has been extreme and does not seem to be ending.
Can Colony Capital Weather COVID-19?
Problematically, Colony's deterioration began long before the virus started. Now that many of its hotel assets (and perhaps senior and independent living facilities) may struggle to pay rent, I imagine the situation will only get worse.
78% of Colony's hotel assets (by room count) are in Marriot (MAR) and 16% in Hyatt (H). Currently, a quarter of Marriot's hotels are closed and the rest are seeing extremely low traffic. While many are betting that these companies will see a swift comeback, I wonder how many are currently booking vacations within the next few months. In other words, I believe hotels will see far-below-normal traffic for many months after the economic closure ends, meaning Marriot (and peers) will likely struggle to pay rent.
The situation is not so different for senior living facilities and skilled nursing homes. COVID-19 has caused most to stop admitting new residents and increase spending on healthcare. Additionally, the inability to see relatives and fear from children will likely cause demand for nursing homes to decline. These facilities usually have low profit margins, so a small decline will likely substantially increase tenant financial risks. Last year, senior housing and skilled nursing facilities accounted for 70% of Colony's healthcare NOI.
Overall, it seems clear that Colony will see a significant jolt relating to COVID-19. It remains unclear that the company will see a "V-Shaped" recovery, as many of its tenants are in industries with high risk of a lasting impact.
Colony Capital has been struggling with profitability for years and has faced significant losses and poor profitability on most of its assets. Since the coronavirus specifically threatens the industries of its major holdings, it has the potential to significantly harm the company at a time when it lacks the necessary financial wherewithal.
Am I saying it is likely the stock falls to zero? No, it could recover, but a dividend cut and equity dilution are possible. Unfortunately, its recovery strategy has been to transition away from its core business to the data center business, where it has essentially no foothold. Instead of reducing its assets and paying off its high-interest debt, the company seems to wish to pursue endless growth by chasing performance. Personally, this strategy seems to improve executive compensation as opposed to shareholder safety.
Now, Colony is undoubtedly very cheap from a book value perspective. From a cash flow perspective, it is less clear due to its thin margins. The company will also take a significant loss due to its significant ownership of Colony Credit Real Estate (CLNC), which is down over 75% YTD.
Overall, CLNY seems to be more of a value trap than an opportunity today. I do not have a position in the stock and do not plan to until guidance arrives. For the time being, I believe management is not making strong pro-recovery decisions and the stock is best avoided.
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