This article is part of our Rising Star Portfolios series.
If you believe commercial real estate has bottomed out, I have a California strip mall I'd like to sell you.
No, really. There actually is money to be made buying and stabilizing distressed neighborhood shopping centers and Retail Opportunity Investments Corp. (Nasdaq: ROIC ) is the "right place-right time-right guy" way to play it. That's why I'm thrilled to add ROIC to my Rising Stars Portfolio.
The seeds for ROIC were planted back in 2007, when the Baker family -- founders of National Realty & Development Corp. -- raised close to $400 million through a blank check company, aka a SPAC (special purpose acquisition corporation), with the goal of opportunistically acquiring a real-estate-focused operating company. Two years later, with no major acquisition prospects and faced with the undesirable option of returning their stockpile (SPACs have a limited amount of time to acquire a company), the Bakers dusted off their industry black book and called up the one man they knew could turn a ton of cash into REIT gold: Enter Stuart Tanz.
Release the Tanz
So, ladies and gentlemen, if I say Stuart Tanz is a real-estate man you will agree. Born into a real-estate family, Stuart has sheetrock running through his veins as he got started early in the business cleaning up trash and making repairs for his dad's shopping center(s). Stuart quickly moved up in the family business and would go on to make a name for himself guiding Pan Pacific Retail Properties from its 1997, $146 million IPO, all the way to its $4 billion sale (including assumed debt) to Kimco Realty Corp. (NYSE: KIM ) in 2006. Tanz proved he knew when to hold 'em and exactly when to fold 'em, as Kimco saw its market value get more than halved after the purchase.
Tanz now reenters the game to guide ROIC's transition from a SPAC to an opportunistic niche-REIT. Rested and richer, Tanz is wisely reaching to the same playbook that paid off for him before: Underpay for troubled grocery store-anchored shopping centers, make cosmetic touch-ups and necessary repairs, and then lease 'em up. Tanz avoids buying lemons by focusing on three acquisition criteria:
- Geography -- Focuses on coastal states with positive population trends and limited space availability.
- Density -- Buys in densely populated areas where at least 180,000 people live within a 1- to 3-mile radius.
- Income demographics -- Targets neighborhoods with median incomes of at least $62,000 a year.
While it is still early, the quality of ROIC's initial purchases point to an effective plan being executed by the right man.
Why I'm buying (and how much)
I'm an asymmetric investor who likes to make big bets on high-probability outcomes that have a seemingly limited downside. Throw in a proven asset allocator, and I'm sold. While ROIC's upside is based mainly on potential, its current value is rooted in cash and backed by real assets. Given the company's current lack of debt, ROIC's reported tangible book value of $9.32 per share serves as my low-end estimate of value, which, based on its current share price, represents only a 5% downside risk.
However, these recent purchases aren't simply worth their acquisition cost; I believe they're worth a bit more. Based on the terms of their initial acquisitions, I estimate that Tanz and company are picking up properties at 10%-20% discounts to intrinsic value. Assuming Tanz uses the $400-million-or-so war chest to acquire properties at 15% discounts, on average, shareholders will be in possession of at least $470 million worth of assets (not counting the use of any debt or leverage). This translates to about $11.30 per share, which would be an 18% return based on today's prices. As to earnings power, I believe ROIC, when fully invested, can comfortably generate somewhere in the order of $35 million to $45 million in EBITDA.
Comparing my estimates against some handpicked niche retail REITs creates an interesting picture:
Price / Book
|Realty Income Corp. (NYSE: O )||3.31||
|Regency Centers (NYSE: REG )||2.27||
|Federal Realty Investment Trust (NYSE: FRT )||4.43||
|Acadia Realty Trust (NYSE: AKR )||2.46||
|Retail Opportunity Investment Corp.||1.04||
Source: Yahoo! Finance as of market close Oct. 27.
Using relative multiples and projecting ROIC's potential dividend and subsequent yield provides a wide range of potential values, from very favorable to wildly optimistic. Again, I peg the "lots of things go wrong" downside value at tangible book value. On the upside, I see ROIC worth between $17 and $26 a share. Given today's stock price of $9.62, this investment provides me with a "too good to be true," 15-to-1 reward-to-risk ratio. With that in mind, I am looking to allocate between 8%-12% of my portfolio to this position.
First of all, I admit that a large portion of my investment thesis is contingent on Stuart Tanz, his previous track record, and his ability to do it again. But make no mistake, all equity investments, in one way or another, are jockey bets. So, after examining Stuart's previous successes, reviewing his initial ROIC deals and interviewing him about his investment strategies, I must report back that I truly like what I've seen. Stuart is passionate about real estate and growing ROIC. Add in the fact that he ponied up $5 million of his own cash to ride along in the Retail Opportunity rodeo, and you start to realize that shareholders are fortunate to have Tanz holding the reins.
Secondly, the state of the economy and commercial real estate is definitely a concern worth considering. Indeed, high unemployment and a prolonged recession would continue to put pressure on retailers, thus increasing the probability of defaults. That's why Tanz and ROIC focus on grocery- and drug-store-anchored shopping centers in neighborhoods with favorable density and income levels. While lower-wage earners are facing double-digit unemployment numbers, ROIC's target demographic are faring much better with rates below 5%. Also, further convulsions in the commercial real estate market actually create additional buying opportunities for Tanz and company.
Finally, another potential risk factor is Wal-Mart (NYSE: WMT ) . Not too many people realize it, but Wal-Mart is the largest grocery seller in the United States. In addition, the company is looking to build smaller-footprint stores, which could do damage to neighborhood centers. While this is a real risk, I believe it's one that will take a decade or more to fully play out.
My Foolish bottom line
Had things gone a bit differently, ROIC could have easily become a casino or a chain of hotels. Instead, what started as a pile of cash and a dream to profit off of the troubled $1.7 trillion commercial real estate sector may just turn out to be Mr. Tanz's greatest opus.
While it's still a scary time for commercial real estate, it is in the midst of the fear and turmoil that the greatest opportunities emerge. Tanz and company ignore the gloomy headlines, and take comfort knowing that real estate is still about location, location, location. Their maniacal coastal focus on drug- and grocery-store-anchored shopping centers in densely populated, moderate-to-high income areas is a sound strategy that I'm happy to be a part of.
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