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The Essential REIT
September 1, 2004
"Writing does for me what giving milk does for a cow." -- H.L. Mencken
"Writing is not necessarily something to be ashamed of, but do it in private and wash your hands afterwards" -- Robert Heinlein
"Writing is like prostitution. First one writes for the love of doing it, then for a few friends, and, in the end, for the money." � Moliere
1. GRouse Hunting: Ego Inflation or Value Creation?
General Growth Properties' offer, announced on August 20, to buy each and every share of Rouse at a price of $67.50 in cash � in the biggest REIT deal ever � has REIT investors scratching their (swelled) heads. One might more easily understand an offer by Equity Office to buy Boston Properties at the same price; after all, Sam Zell has been accused of being a Serial Acquirer, whereas the guys at GGP have, until recently, developed a well-deserved reputation for being very disciplined about what they buy and what they're willing to pay. So General Growth's offer to buy every share of Rouse at a nice round 33% premium over Rouse's pre-announcement closing price of $50.61 has generated some very uncivil remarks from normally polite REIT investors. "What can they be thinking?" is a censored version of these reactions.
At first blush, the deal doesn't make a lot of sense for General Growth � and maybe at second and third blushes, too. Although there's no doubt that most of the Rouse malls are of fine quality, and will certainly be complementary to GGP's product offering, the price being paid for them is enough to embarrass even Harry Winston (not that I've ever shopped there). Not only is General Growth willing to pay a stock market price premium of 33%; looked at from a real estate viewpoint, it appears that it is willing to pay a "nominal" cap rate of about 5.25% for Rouse's malls. Sure, malls are pricey these days, but isn't this like paying $89 a share for Amazon stock in January 2000?
Ah, but it's rarely that easy, is it? General Growth, as a company, has never been sentenced to do hard time at Reitville Correctional for reckless endangerment of its shareholders' capital; indeed, its capital allocation skills have been widely acclaimed by REIT investors. John Bucksbaum and his family are proven mall veterans, not dummies, and they've been very adept at creating lots of value for their shareholders over the years. Their annual dividend has grown, since 1993, at an average annual compound rate of 8.4%; the number of REITs who can make that statement can be counted on the toes of Sammy's right paw. GGP's total returns have handily beaten the RMS index since its IPO in 1993 (see below). And, the stock has been the second-best mall REIT performer over the past 3- and 5-year periods. One doesn't develop such track records by being foolish with one's capital.
So, might there be method to this REIT's apparent madness? Although it is certainly true that academic studies show that most mergers create as much value for shareholders as do class action lawyers, some (both mergers and lawyers) are very effective. Furthermore, the Bucksbaum family has a major ownership stake in General Growth (insiders own, collectively, almost 23% of the outstanding equity), which suggests that they are less interested in building empires and more motivated to create long-term shareholder wealth.
So this may not be the waste of corporate assets that it appears to be. Well, which is it � smart or stupid � or both? Unfortunately, we won't be in a position to make a confident call for several years, and even then there may be no definitive answer. I guess that's the beauty of sports events; we know inside of one minute who's won the 400-meter dash. A football game takes only, er, five hours. But it can be instructive to debate General Growth's decision and, in that vein, I present here for your consideration a discussion between Ursa Beare and Toro Bulley; Ms. Beare was so outraged by this merger announcement that she no longer cheers for the Chicago Cubs, while Mr. Bulley is so stoked that he has begun to write love letters to Matthew Bucksbaum.
Ursa. This is not only the largest merger in the annals of Reitland, but also one of the most stupid. Most REIT mergers offer the acquired company's shareholders a price premium of 5-15%, and a number of them are take-unders. Many are priced so that the acquirer's NAV is enhanced by the deal. Simon offered Chelsea's shareholders a premium of just 14.4% (though at a much higher NAV premium), and Chelsea was (and is) one helluva company, perhaps one of the best REITs ever. What does General Growth think it's doing, paying a 33% stock price premium and a 5.25% nominal cap rate for Rouse's assets? This is one bizarro takeover.
Green Street has estimated that the premium over Rouse's prior market price amounts to $1.7 billion, not including transaction costs. How are they going to justify this giveaway? Merger "synergies" are modest in Reitland, and all that General Growth is likely to save will be corporate overhead expenses, which run around $20MM annually. Maybe they can save twice that, but who cares when we're talking a $1.7 billion premium? Not too long ago Donald Trump, if he'd been smart enough, could've bought the biggest REIT in Reitdom for less than $1.7 billion. And GGP isn't issuing overpriced paper to pay for this deal; it's all cash! Any way you slice it, Toro, this is one very expensive deal for GGP's shareholders.
Toro. But, Ursa, you are looking at this deal from an entirely erroneous perspective. For General Growth, this is NOT an asset acquisition, and shouldn't be analyzed as such. John Bucksbaum has made clear that his strategy is to operate a mall enterprise that will grow its cash flow and dividends at unusually high rates, compared with other REITs and real estate owners, and so far he's kept his promise. Check out that price chart that Reitnut earlier inserted into this weird newsletter. Rouse has some great assets, in some excellent locations. Although Rouse's malls have been well run, they contain lots of remerchandising opportunities, including street-front locations, movie theatres, restaurants and other venues. GGP's superb management team will have the opportunity to add value not only to Rouse's assets, but also to generate higher net operating income at GGP's existing properties.
How would you like to be the leasing team at Chico's, or even Gap, and have to sit down with the GGP guys to negotiate your space needs over the next 24 months? Bulked up with the Rouse assets, General Growth will be able kick some serious butt (assuming that the retail sector of the economy remains relatively healthy). Indeed, the net present value of the incremental increases in the net operating income of GGP's combined properties as a result of the merger will easily exceed that $1.7 billion merger premium.
Ursa. Don't hold your breath. GGP's Q2 net operating income before depreciation was just over $300 million, and for Rouse it was $166 million. Add 'em together and multiply by four and you get $1.9 billion in NOI. If GGP is able to increase its profitability by 10% as a result of this deal (a big IF), that's only $190 million per year, and it would take nine years to recoup that huge merger premium. Not a very attractive return, if you ask me. And nothing was presented in the conference call to help us get to any better numbers. Hey, "we've been here, done that" with some of Sam's deals � and even some of Simon's earlier ones. Bigger, in real estate, ain't necessarily better � at least, no one's proven that yet.
Toro. But in the retail sector, unlike offices, huge negotiating leverage with tenants, generated by large size and market dominance, provides a very substantial competitive edge. It's important to be an 800-pound gorilla when dealing with national, and even regional, retailers. The Oaks Mall in Thousand Oaks would be a lot less valuable in the hands of Sammy G. Retriever and his associates than it is in the hands of Macerich (though Petco and Petsmart would undoubtedly get good lease terms). Operating synergies increase with scale, as do joint venture opportunities, e.g., Simon Brand Ventures. The value of Rouse is a lot greater to GGP than it would be to most other investors, and GGP will prove its value over time with much more rapid growth in cash flow and dividends. And that is what the Bucksbaums have concluded. On the basis of their stellar track record, they are entitled to the benefit of the doubt.
Furthermore, the pricing of this deal isn't terribly weird even if we look at it on the basis of an investment in real estate (which the Bucksbaums do not). Rouse recently bought a single asset, Providence Place, at a nominal cap rate of 6.1%. But that was in Providence, Rhode Island, for Chrissake, and sales/sq.ft. are only in the mid-$400 range. Simon bought Stanford Mall at a cap rate of about 5.6% (sales of $600); and nobody complained too loudly when GGP announced its Las Vegas acquisition (Grand Canal Shoppes, at an estimated 5.8% cap rate). Admittedly, not all Rouse's malls are that productive, but some of them are irreplaceable jewels. Furthermore, cap rates have continued to decline since those transactions were concluded.
Ursa. Look, Toro, let's get real. Rouse's malls average sales/sq.ft. of $439, which is good but, as a group, they're not shooting the lights out. Occupancy is 92%, so there's little or no room for improvement there. And tenant occupancy costs are pretty high, at 14.8% of tenant sales. There's no low-lying fruit here available for GGP to pluck, and so no reason to think that these malls should trade hands at a nominal cap rate of below 6%. This is a good deal only for Rouse's shareholders; ten days after the announcement they're still giving each other high-fives.
Toro. Heck, Ursa, we can debate 'til the French cheer President Bush about the value of Rouse's assets as commodity properties, but this isn't a property deal. General Growth ain't going to flip these assets any time soon. The properties, though perhaps a bit pricey as pure real estate, will be integrated with an operating business whose shares are publicly traded. And that's where we ought to focus. What kind of return will GGP generate on these assets when combined with GGP's existing properties, and how will that fit in with its weighted average cost of capital and shareholder return requirements? Those are the questions we ought to be asking.
Ursa. You'll tell me about it anyway, so I won't even bother to ask. Go ahead.
Toro. Thank you. I look at it this way. Assume, for the sake of discussion, that General Growth obtains an economic cap rate of just 4.5% from Rouse's malls, and a similar return from its other assets (net of property sales); this is, you'd agree, pretty conservative. But that's only part of the story; the real issue is the expected internal rate of return (IRR) on these acquired assets. If GGP increases the operating income from its Rouse malls by just 2.75% annually, and if Rouse's assets appreciate in value by a like amount each year, it will have generated an IRR of about 7.3% on its purchase price.
Then, we need to compare that return to General Growth's weighted average cost of capital (WACC); if the IRR meets or exceeds it, then that deployment of capital was successful for the shareholders. WACC for any company is, of course, a guess. However, the debt component is fairly easy to forecast; let's assume that long-term debt will cost GGP about 6.25%. Equity cost is somewhat harder to estimate, but let's assume that equity investors expect a 9% return from their investment in GGP when it uses debt leverage of approximately 60% (this 9% leveraged return is somewhat equivalent to an unlevered investment return of about 7%, and seems reasonable in view of today's average mall nominal cap rate of just under 7%). What results is a WACC of 7.3%. This "hurdle rate" is very similar to the rate of return that GGP is likely to earn on its investment, as I suggested earlier. Indeed, 7.3% should be relatively easy to achieve, based on those conservative assumptions.
Ursa. OK, Toro � can I call you Hornface? You are just plain wrong. Fixed rate debt is apt to cost more than 6.25%, on average, over the next 5-10 years, and shareholders will probably demand more than 9% returns on their investment in GGP (after all, that's 300 bps below the long-term average for equity REITs). Equally as important, even if GGP's WACC is 7.3%, it probably won't earn a 7.3% IRR on its investment; those 2.75% increases are aggressive, as post-cap ex NOI growth won't be that high, and capital appreciation won't be that substantial � not from these price levels. But, even if you are right, that makes Rouse a fair deal, but not a particularly appealing one.
Toro. I can play the name-calling game, too. How about I call you Clawhead? Anyway, first of all, keep in mind that REIT stock prices are, today, at levels from which only a fool should expect to generate better than 9% total returns from an investment in them. An average annual total return of 9% on REIT stocks should please all but the most greedy of investors, and the risk in GGP's stock is lower than most � its extra debt leverage is offset by its stable cash flow streams, a diverse asset and tenant base, market clout, and a quality management team. Second, the deal will be value-accretive, rather than just "fair," if, as I suspect, having Rouse enables GGP to goose the returns and profit margins on its existing assets; this is a key part of this deal that nobody gives GGP any credit for � analysts and curmudgeonly investors figure, "If you can't count it, ignore it."
Ursa. But wait, you mulish bull. You are ignoring the leverage factor. When this Rouse deal closes, General Growth will be choking on debt � by management's own estimation, the debt to market cap ratio will be 71%, which compares to the mall REIT average of only 55%. Even worse, a large portion of GGP's debt, at least for a while, will be variable rate. Heck, even at June 30, 28% of total debt was of the wrong (variable-rate) kind. These numbers aren't pretty, and subject GGP's shareholders to huge risk should interest rates finally wake up and begin to lurch upwards.
Toro. Things are not always what they seem. First, GGP has always been able to handle an above-average amount of debt, due to its stable cash flows. Sure, 71% is a tad high, but they'll be able to get this down to 60% within a couple of years, particularly if they sell off some of Rouse's non-mall assets. Second, the fixed charge coverage ratio will still be within the bounds of reason after the closing, at approximately 1.45x � 1.50x, and management has promised to bring this up to 2.0x "as soon as possible." Third, GGP has used substantial debt leverage at times in the past, and has managed it well; indeed, some believe that GGP is one of the very best REITs at balance sheet management.
And, a final point. Barry Vinocur, in his "REIT NEWSHOUND.COM," has stated that his sources told him that Simon bid $63 per share for Rouse, and tried to get the bidding reopened so that it could offer one final � and perhaps higher � bid. If Simon, which was so disciplined in its siege of Taubman, was willing to pay $63 or more for Rouse, does that suggest that General Growth is overpaying? Sounds to me like you big fuzzy creatures haven't yet woken up to the fact that it's a seller's market for quality malls, and for good reason. They are among the few sectors in real estate today with solid growth prospects, and lots of embedded NOI growth. Shop-space retailers are thriving. Why shouldn't mall REIT owners benefit disproportionately from the injection of huge amounts of fresh capital into the world of real estate?
Ursa. I stand by my claim, bullyboy, that GGP is hubristically overpaying for a very good mall portfolio. It wasn't patient enough, and perhaps felt like it "had" to do it (did the devil play a role here?) in order to keep up with Uncle Simon (though I don't think that GGP needed to get any larger to be a kingfish in the mall business). It is using too much variable-rate debt to finance this monster acquisition, unduly exposing its shareholders to rising interest rate risk. And the fact that shareholders don't like this deal is evident by the vertigo experienced by GGP's shareholders during the several trading sessions following the announcement.
Toro. And I stand by my view that, in the fullness of time, the doubters and curmudgeons who have never understood General Growth's business model and have underrated its management team will have more than egg on their Scrooge-like faces. Profit margins will increase, IRRs on this deal will exceed GGP's weighted average cost of capital, the balance sheet will shape up nicely and GGP will be stronger than ever. Those who remain loyal to the company will, with a bit of patience, continue to generate well above-average shareholder returns. And, need I mention, the stock has perked up nicely this past week.
OK, Ursa and Toro; thanks for letting me eavesdrop on your heated conversation. If you want to know what I think, it's that both of you are right � and wrong. The truth, as so often the case, lies somewhere between polar opinions. This is a very solid strategic acquisition for General Growth, one the shareholders will appreciate over time. However, despite Toro's arithmetic acrobatics, they are paying a rich price for Rouse, which has caused some temporary NAV dilution and increased investment risk. But it is certainly not a large blunder, and the investment will pay for itself over a period of time � assuming, as I do, that the mall business continues to remain solid.
And, as is so often the case, the market has it right. GGP's stock has not declined anywhere near the amount that would be warranted if the entire merger premium (vs. pre-announcement market price) were a waste of GGP's capital, but the stock has sold off, particularly vs. GGP's peer group, reflecting the increased short-term risk and the sizeable NAV dilution. The bottom line, I think, is that those who own GGP and have a reasonably long time horizon will regret dumping their shares � though tapering positions back a bit to reflect increased risk wouldn't, to this jaded observer, be an unreasonable move. For what it's worth (not much), that's what I have personally done.
Disclosure: I and/or the firm(s) to which I provide services may from time to time have long or short positions in some or all of the stocks (if any) mentioned above. Further, this "newsletter" is not intended as a recommendation for the purchase or sale of any particular security and is not intended to be investment advice � or any other advice for that matter. The statements made in this newsletter are my own personal opinions, and do not represent the views of any other person, real or fictitious, or even the views of Sammy, my Golden Retriever. � 2004 Ralph L. Block
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