Post of the Day
February 11, 1998
From our AOL
Trump Hotels & Casino Board
Subject: Re: new investor
Hi there, Trumpsters. I have received mail from a couple of you to come over from the REIT board here and say a few words. I read over the last 30 or 40 posts, but pardon me if I repeat some things you all already have covered. Brigham notes that: [[ "I thought that REITs can pay dividends out of cash flow, even if earnings are non-existant or modest." ]]
He is in fact quite correct about that and many do. REITs calculate their "earnings" as something they call "FFO" or Funds From Operations. Basically that's close to GAAP earnings with the tax adjustments like depreciation and amortization backed out. As in your world, analysts adjust that reported FFO to account for "Capitalized Non-Revenue Enhancing Expenditures." In the case of a hotel that might be things like expenditures for furniture, re-painting, or putting in new vinyl wall covering.
What REIT analysts are looking to cut out is any items that are being capitalized by management but are in fact really recurring expenditures that are necessary to keep the income flow at current levels. We don't mind management capitalizing expenditures for things that result in more rentable area, or higher rents, but we don't count fixing the roof as "Revenue Enhancing," even though we do want the roof fixed. Analysts call their adjusted FFO by various pet names but you will see CAD (Cash Available for Distribution), FAD (Funds Available for Distribution) and AFFO (Adjusted FFO). The number analysts are trying to get right is something analogous to "Free Cash Flow" in the general corporate world.
What all this means with respect to The Donald's company is not clear to me, but I am not a casino analyst. All I can say is that before anyone seriously plunks down big cash they will certainly, as you have all noted, first look at DJT to determine its recurring, after Cap-Ex cash flow.
If it were my job to structure that deal I'd be listening to Brigham and the rest of you folk and be trying to figure what that real cash flow might be. In particular I would want to come to grips with what you have to pay to keep The Donald's Atlantic City properties up to snuff in style and amenities so rollers keep coming in to gamble. Then I'd want to check the likelihood that that revenue will increase over time, either by itself, or with some additional capital expenditure. Finally I'd try to guess how a REIT analyst would value those cash flows based upon his certainty or lack ot certainty that the revenues will be there.
Buy-side analysts have more leverage (over time) in the REIT world than they do in the general corporate one for a simple reason. The REIT law says that REITs must dividend out 95% of their taxable earnings. If a REIT wants to grow it needs capital, and it can't retain much from operations. It therefore must issue secondary offerings of equity, often annually. If the big boys on the buy side don't have faith in the quality of the earnings, they either drop the price or don't buy at all. If the price drops to the point where new acquisitions cost more than they can earn, the game is over until things turn around and the equity window closes.
If the "equity window is closed" the only way a REIT can grow is through borrowing more, but the market is not very tolerant of high debt levels in REITs that don't have assets under long-term leases. The average shopping center REIT has an EBITDA debt service coverage ratio of 3.2 x but it has lots of anchor tenants on long leases. The average hotel REIT has an EBITDA coverage ratio of 5.1 x. The average casino guest stays a shorter time than the average hotel guest, and the amount he spends per day is less predictable.
Any REIT that takes on the Trump company will have to be pretty large, and even then it will have to issue a lot of stock to pay down a lot of his debt. I would be pretty surprised if the deal could be structured with more than $500 million to $750 million in surviving debt. You all can research as well or better than I how hard the documents say it will be to pay off Trump's lenders, but whatever the cost of that is, it will be deducted from the price paid. There may well also be some sort of pre-payment penalty or "make-whole" provision, but I have not looked to see. Maybe there's some way to "de-feaze" them that the market would accept. The buyer might go out and buy some Treasuries and swap them for the debt so the debt-holders would get the same cash flows but with greater security. There's some cost to doing that, but it's been done before plenty of times. Even I have worked on a couple of transactions of that sort.
Do note, though, that when the debt is paid off it will free up a lot of cash flow to pay dividends and if you get the CAD calculation right you could maybe sell that 1999 pro-forma cash flow to equity REIT investors at a 12+ x multiple (hotel REITs on average are selling now at 16.7 x 1998 CAD and 12.5 x 1999 CAD expectations.)
All I mean to say by this long post is that (as you all already know) REITs will not be an automatic magic cash cow for DJT holders. They will worry about exactly the same business risk/reward issues you all do, and they will judge DJT as an alternative investment to hotels, offices and other real estate plays they might make. They will (I believe) think that gaming is considerably riskier than hotels and will look for a higher return. They will certainly (IMNHO) be forced to end up with relatively minimal leverage in the combined companies, post-merger -- maximum 25% with 4 to 1 coverage on interest on the debt from CAD I would guess.
I think proposed changes in the "paired-share" REIT law, if they finally pass, will be specifically triggered by Congressional concern about REITs owning casinos. To the extent they or the Treasury can make this a hard thing to do, you can expect they will, notwithstanding gaming's formidable lobbying abilities. Any REIT that takes DJT on can expect that all the tax allocations will be looked at very carefully on audit.
That does not mean no REIT will try, only that this will not be a teeming auction of frenzied bidders. This deal, whoever structures it, will require a bunch of public equity sooner or later. Not many REITs can step up to that plate for this big a deal. There are only 39 equity REITs of all property types with a public market cap of over $1 Billion, only 11 with a public market cap of over $2 Billion, and only 4 with a public market cap of over $3 Billion. (If any of you are intrigued by playing what-ifs, send me an E-mail and I'll include you on our distribution list for a daily EXCEL spreadsheet that lists all equity REITs, their FFOs, market caps etc.)
I thank two of you for the invitation to come chat. Please come visit the real estate board (KEYWORD: REIT) whenever the urge strikes you.
( TMFYorick@aol.com )