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Real Estate & REITs
Re: Bluest of the Blue for 2004

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By Reitnut
February 17, 2004

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

OK, as I threatened a day or two ago, I would like to submit a nomination for Chelsea (CPG) for the B of B list. First, though, a disclosure and a comment: Disclosure � my personal portfolio, my wife's small collection of stocks, my mother-in-law's REITs and my mother's REIT collection all include CPG, as does Bay Isle's model REIT portfolio. We have owned this stock for many years. And, comment: This post does not address the question of CPG's valuation. We all have different views about how to value REIT stocks, and my own view is that CPG remains attractive on a long-term basis when measured against other REIT stocks (though it is expensive vs. its own historical trading metrics). Barry would note, however, that past historical yardsticks need to be put in some perspective when looking at CPG, as its track record has become longer and more impressive with the passage of time.

OK, why do I nominate CPG?

Outstanding, Proven Management, Effective Capital Deployment, etc. I will cover here all the appropriate sub-topics of the "Management" section, i.e., history of value-creation, avoiding dumb transactions, good property management, understanding shareholders' risk tolerance limits and return objectives, maintaining good control over the business and good capital allocation skills.

Any way you slice this company, you cannot come away with a conclusion other than this: Chelsea's is one of the finest management teams in the REIT industry. Their history of value creation is awesome. Equally as important, they have been, with but one exception, outstanding capital allocators. Examples: Just after they went public, they had about 3-4 peers in the outlet center sector, all of whom were building outlets here, there and everywhere, particularly out in the desert and other god-forsaken places. They saw a glut of outlet centers coming, and became very conservative in their new developments. They did not ramp up their development pipeline until well after their peers got into a heap of trouble from overbuilding.

Further, they figured out very early that there were two essential ingredients to highly successful outlet centers. First, location, and second, brand name retailers with some "cachet" in the marketplace. Building centers in close-in locations has been problematical for outlet center owners, as the retailers don't want to offend (or siphon profits away from) their mall customers, so CPG had to work very hard to build centers close to major metro areas and tourist destinations. Second, they figured out that no one would drive 20 miles to buy ordinary brand merchandise such as Nike, et al, so they worked out strong relationships with designer names such as Ralph Lauren (Polo), Adrienne Vitidini, Coach, et al.

And over the years they have become very successful in this strategy, as the average sales/sq.ft for CPG's outlet centers is now almost $400 ($383 at the end of '02), and their centers have consistently been 98-99% leased. This provides CPG with good internal growth, as tenant productivity has been sufficient to justify reasonably good rental rate growth as leases expire. The average sales/sq.ft for mall properties is about $365/sq.ft., so tenants generate more sales at CPG's properties than they would at the typical mall (though their margins are likely lower, due to the discounts offered at the former).

The company's new developments have been very successful, continually generating initial returns in excess of 10%. They continue to focus on in-fill areas (e.g., pending developments and pre-developments include Chicago, Seattle, Philly) and tourist destinations (e.g., The Poconos, New Jersey Shore). And they have been very successful with JV developments in Japan, where they already have been extremely successful with three projects; they are working on a fourth, outside Fukuoka, Japan's fourth largest city. And they have begun a new development in Mexico. Admittedly, this development focus does increase CPG's risk level somewhat, and is the reason why I didn't nominate CPG last year. However, they have done such a good job with these projects � never missing a projection � that I think this more aggressive strategy, by itself, shouldn't knock them out of the B of B list.

And in the last two years they have become a major consolidator of the outlet center industry by buying a number of assets at very attractive prices, totaling $850 million of assets (which Green Street estimates is 15% of the total square footage of the outlet center industry). They have bought at very high cap rates, and are converting some of these assets to its "premium" brand, operating others at lower price points and selling off those without a prayer of generating much of a return. In a particularly shrewd move, CPG bought an existing outlet center near the Las Vegas strip, just before completing a major premium outlet center there. These two assets will complement each other, and CPG is able to control any competitive threat that might otherwise have arisen.

Part of "Proven Management" is the avoidance of "dumb mistakes." CPG's only real blunder occurred when it launched an Internet-based project a few years ago to develop websites for retailers, e.g., Polo, Timberland, et al. They found that, while they were indeed able to sign up a number of major retailers, the costs were higher than expected, and the returns lower. But, they were disciplined, and promised their shareholders that they would limit their exposure to the project by limiting total funding to $60 million, and they have lived up to this commitment. They decided in March '03 that they could not achieve sufficient cash flow from "Chelsea Interactive" to "break-even and self-fund newer brands before reaching our stated funding limit." So, the company is putting no more money into this project and is attempting to find a buyer. In any event, the ultimate maximum loss won't be large in relationship to the total equity market cap of the company ($3 billion).

Among other "management" criteria, property management and leasing has been stellar; bad credits and bankruptcies have not been a problem for CPG, as evidenced by its consistently high occupancy rates. Bad debt expense was 0.7% of A/Rs as of the end of 2002. CPG seems to understand its shareholders' risk-tolerance limits and return objectives; thus they were willing to cut their losses in Chelsea Interactive despite some signs of pending success, and they cancelled a development in South Korea when geopolitical issues loomed in North Korea. They are doing one development in Mexico, but won't do others if a satisfactory hurdle rate isn't likely to be achieved. And they have, more recently, been steering clear of acquisitions as cap rates have come down. And they have never, to my recollection, lost control over their business at any time.

Shareholder-friendly use of equity capital. This point is covered above. In addition, the company hasn't been reluctant to share their success with the shareholders, as evidenced by large dividend increases. Last year, the dividend was boosted by 10.3%, and I expect another sizeable increase with the very next dividend announcement. It hasn't done much stock repurchasing, but this is because (a) the stock rarely trades below NAV, and (b) they can generate very high returns on retained earnings via the development process.

Balance Sheet Strength. No issues here. Debt + pfd stock as a percentage of total estimated asset value is only about 42%, compared with over 50% for the average REIT. Interest coverage ratios for the past three years were consistent at 2.4x to 2.6x, and interest coverage at Q3 '03 was 3.8x. The company's credit facility at the present time is at Libor +1%, indicating a very moderate level of risk in the eyes of their commercial bankers. At Q3, variable-rate debt was $245MM, or about 26% of total debt. This is a bit higher than I like to see, but isn't a source of worry given the company's development orientation � for which short-term variable-rate construction loans are appropriate. That $245MM is only about 8% of the company's total equity market cap. So, the balance sheet is solid.

Appropriate Geographical Strategy. The key here is "appropriate." Chelsea has always been a "national" outlet center owner and developer, and its two most productive domestic assets are located on both coasts, in New York and in California (Woodbury and Cabizon). It has held to its strategy of focusing on urban in-fill and tourist destination locations, as well as foreign locations where it teams up with strong local players and where it can provide some "value add" by virtue of its strong relationships with nationally-known, brand-name retailers. And it owns, manages and develops only outlet centers, so it is very focused by property type.

Corporate Governance. One area where CPG could stand a bit of improvement is on corporate governance. It has lacked a desirable number of independent directors, and has a staggered board; but no shareholder rights plan is in place. However, outside of these structural issues, the governance isn't all that worrisome. There are no material relationships or dealings with insiders, and over 80% of the independent directors own over $200K in CPG stock. Like most REITs, Chelsea has provisions in place making a hostile takeover difficult. All in all, a satisfactory rating here, but room for some improvement.

Dividend Sustainability. There is no issue regarding dividend sustainability. Assuming no material adverse change in the business, the only issue is how much CPG raises its dividend from year to year. The current payout ratio (based on AFFO) is only 65%, so there is lots of room for dividend boosts.

Performance. How has CPG done as an investment over the years? I don't have specific data to offer, but if we eyeball a long-term chart at Yahoo Finance, CPG's performance has been impressive, to say the least. If we go back to late 1995, the RMS index has delivered a total return of about 160%. During that time period, it looks as though CPG has delivered a performance of about 270%. A May 2003 Green Street report shows that, over the three years then ending, CPG has been able to increase its estimated NAV by over 60%, compared with only a nominal increase for the average REIT.

Chelsea has also been able to grow its AFFOs by something like 10% per year, driven by developments, acquisitions (more recently) and reasonably good internal growth. This is, of course, a much higher growth rate than most REITs have been able to muster. And AFFO growth for this year and next should also be close to, or in excess of, 10% in each of such years. This capacity, IMO, suggests that CPG is a very unusual REIT.

The bottom line, for me, is that CPG's history of creating value for shareholders � which I think is likely to continue � is such that it belongs in the B of B list (though, given lofty shareholder expectations, the relatively high NAV premium (if one can accurately estimate NAVs in this very small sector) and aggressive game plan gives it a somewhat higher risk profile than for many others on the list). I would note, however, that NAV analysis is probably not as good a way to value the stock of a Chelsea than it is for most REITs, given its very high growth rate and difficulty of ascertaining estimated NAV. I really like this company, and strongly recommend it for the B of B list.

Ralph


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