Another GGP Spin-off: Rouse Properties Seems Undervalued

General Growth Properties (GGP) is a real estate investment trust with a 15B market cap that emerged from bankruptcy at the end of 2010 and has Bill Ackman/Pershing Square as a well known influential investor. Directly coming out of bankruptcy, the company spun off Howard Hughes Corporation (HHC). The idea was that GGP contains the developed cash flow producing malls in a REIT structure, while HHC contains undeveloped assets and other types of real estate such as master planned communities.

HHC has Bill Ackman as chairman, has a lot of insider ownership and the new CEO bought $15M of warrants when he joined the company. T2 values the company in this presentation between $77 and $141/share while the current price is $52. Maybe I'm going to do another write-up on HHC in the future, it's also interesting, but the focus of this post is going to be on Rouse Properties, Inc (RSE). It's a more recent spin off from GGP (spin off date was 12 January 2012). RSE is going to be a REIT and it contains 30 Class B malls located all over the USA. The B-malls have worse metrics such as tenant sales per square foot and occupancy rates than the other properties inside GGP, resulting in potentially improved public market valuation metrics for GGP post spin-off. A company presentation about the Rouse Properties spin-off can be found here.

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Shareholders of GGP have received just 0.0375 shares of RSE for every GGP share, creating a classic spin-off situation were existing holders might decide to dump the new insignificant position. And there is some indication that might be the case. The company is currently trading at roughly $12/share while it has planned a rights offering at $15/share to raise 200M in capital to redevelop and refresh properties. The rights offering will be back stopped by Brookfield Asset Management (BAM), a big asset management company that owns a 37.2% of GGP and as a result an equally big part of RSE. Brookfield has a lot of experience in real estate and would presumably not agree to backstop a $200M rights offering for just a $6M fee if it didn't think the company wouldn't be worth $15/share. Rights offerings are usually done at a discount to fair value to create an incentive to participate.

Valuation

The easiest way to value real estate is by looking at the cap rate: the expected yield a property will generate after subtracting operating costs and assuming it would be bought without leverage. If a fair yield for some property would for example be 10%, and the property would be generating 100,000 of income a year, the value of the property would be 1 million. The previously linked company presentation contains indicative equity values based on the 2010 financials and cap rates between 7.5 and 8.5 percent.

I created a quick excel sheet that gives us an equity value based on the most recent "Core NOI" (approx. 150M this year, down from 160M last year), various cap rates, subtracting the debt and adding back the cash that's going to be raised.

If we would assume that the range of cap rates that the company is using is reasonable it would imply that the equity is worth between $17 and $21/ share: significantly more than the current $12 share price. Problem is that the company has a lot of debt and the valuation is quite sensitive to changes in cap rate or core net operating income (Core NOI). A cap rate around 8 percent seems pretty reasonable. GGP itself is currently trading for a bit less than 7 percent, but it also has higher quality properties so it deserves to trade at a lower cap rate.

Another valuation check is to look at the book value of the real estate. The Form 10 filled before the spin-off contains the following table with balance sheet data:

If we would take the investments in real estate at cost value/total assets as valuation, add the $200M in cash that is going to be raised and divide by the number of shares out standing post rights issue we get a share price of $13.3. Not as high as the valuation based on cap rate, but still above the current market price.

Conclusion

Although RSE seems at the moment undervalued, part of the under valuation is also the leverage at work. If we would assume an 8% cap rate, the total real estate value is 1875M while the market is currently valuing it at 1560M: a discount of 17%. Because of the leverage this translates to a 43% discount in the share price, but the fundamental margin of safety is the underlying 17% discount.

The value of real estate is less volatile than that of other asset classes and therefore having a relative high amount of leverage is not directly problematic. A 65% LTV ratio is very common in commercial real estate, and buying real estate post the 2008 financial crisis in the USA doesn't sound that bad.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in RSE over the next 72 hours. I receive no compensation to write about any specific stock, sector or theme.