(G)rouse Hunting…

I’m not really big on hunting except at flea markets and stock markets, and lately my hunting has proved rather fruitless in the latter. It’s often that way. When the stock  market is down, like it was in September and October, I begin to find situations that look interesting. In fact, everything begins to look a bit interesting. But as soon as the market moves up 10%, I can’t help myself, I compare today’s prices to the prices 10% ago and begin to get discouraged.” Why didn’t I buy this back then?” I moan. “Why am I not more invested?” or maybe “Why am I not invested in the right thing?” It’s about that point that I get the itch to buy. “Buy before it’s too late!” resonates in my head. “Buy before the market goes up another 10%!” But as soon as I hear those little voices, I know it’s waaaay too late, it’s long past the time to buy. Yep, when I get the urge to buy because the market is moving up nicely (well, usually the shares I’m holding are increasing less than the others) I know its time to sell. It’s a kind of contra indicator. And we’re just about there.

However, I did come across one ‘special situation’ that might be interesting: Rouse Properties (RSE). It is a recent spin-off from General Growth Properties (GGP), the company that emerged from bankruptcy in late 2010. You will remember that GGP spun off the Howard Hughes Company (HHC) when it emerged from bankruptcy, and HHC stock was an interesting performer (and one of my holdings) in 2011, almost doubling by last April, before falling back towards its initial spin-off price back in October of last year. It’s now trading some 20%-30% higher than that.

Before I present my quick analysis of Rouse, all you readers should be aware of one thing; I know almost nothing about real estate investing. In fact, my only exposure to real estate as an investment has been the purchase and sale of several houses and apartments, and I have to say, my wife has proved far better at spotting a bargain than I ever have. So take the following analysis with a pinch of salt and remember to do your own evaluation before investing.

There are a number of factors that make Rouse an interesting investment prospect:

1. Each GGP shareholder received a relatively small number of shares in Rouse; holders of GGP received .0375 shares of RSE for each share of GGP held on the effective date. Thus, many holders are likely to sell off their odd lot holdings in RSE with little regard for price.
2. Rouse is a small cap stock (about $400 million today), making it less suitable for many institutional investors who hold GGP, again creating a ‘forced’ sale of certain shares.
3. Rouse is being recapitalized through a post spin-off rights offering, backstopped by Brookfield Asset Management (a 37.2% holder of the company at spin-off), at an exercise price of $15 a share, a price significantly higher than today’s market price of $10.77. This means that Brookfield will be injecting close to $200 million into RSE at a valuation 25% above the price an individual investor can purchase the shares for today.
4. Rouse has stated that it intends to qualify as a REIT of US income tax purposes but is not yet paying a dividend and has yet to announce what the dividend will be (uncertainty can be your friend)
5. The company is relatively easy to understand.

But there are also a few things I don’t like about the investment proposition. Primary among these has to do with management incentives; I generally like to see a lot of ‘skin in the game’ as far as management goes. In this case, not only does Brookfield have a major stake in Rouse (37.2% before the rights offering and up to 54% after) but they will provide management for Rouse under contract. As far as I can see that means management will have relatively little ownership and will be paid as ‘professional managers’ rather than entrepreneurs. That’s a big negative in my book, but let’s see if there are enough countervailing positives to interest us.

Spinoff Background

Last summer GGP disclosed they would spin-off 30 class B regional malls into a separate public entity to be named Rouse Properties. Besides the usual reasons given for a spinoff, improving “..operational efficiency and .. financial performance..”, management specifically indicated that the spinoff would “allow GGP’s management team to focus on its core business of owning and operating premier malls”, and thus increase the attractiveness of the GGP real estate portfolio by disposing of the lower quality class “B” malls.

The spinoff was declared effective 12/30/11 and shares of Rouse were distributed 1/12/12. Holders of GGP shares on the effective date received about .0375 shares of Rouse common stock for each GGP share held, making the Rouse share count at spin-off about 35.5 million shares. In addition to Rouse common shares, GGP shareholders also received a similar number of rights. The rights allow a holder to purchase at exercise 1/3 of a share of Rouse common stock at $15 per share (with no fractional shares to be distributed). While the terms of the rights offering were set prior to spinoff, the timing was not, and still has yet to be announced. Brookfield Asset Management, a 37.2% holder of GGP common, and thus a 37.2% owner of Rouse shares, agreed to backstop the rights offering for a $6 million fee. Since Rouse shares have traded significantly below the $15 rights exercise price since the spin-off was effected, it is likely that Brookfield will have to purchase all the shares allocated to the offering. When the rights offering is concluded, the number of outstanding RSE shares will increase from 35.52 million to 47.39 million.

I assume the purpose of the rights offering was either to provide 1) needed working capital (perhaps required for approval of the spin?) or 2) growth capital (Rouse intends to qualify as a REIT and so will have to distribute almost all future income and capital gains). In its SEC filings the company was non-committal as regards the proceeds of the offering:

“We currently anticipate that we will use the net proceeds of the rights offering for general operating, working capital and other corporate purposes. Our management may allocate the proceeds among these purposes as it deems appropriate. In addition, market factors may require our management to allocate portions of the proceeds for other purposes.”

Valuation

At this point I should probably compare the financials of RSE with other publicly traded regional mall real estate companies to see if they are relatively ‘undervalued’, but I’m not going to do that. I don’t think that relative valuation is all that important. How do I know that all the class B mall REITs are not under or overvalued? As I wrote above I’m not an expert in the real estate sector (a mild understatement!), so I don’t. Instead, I’m going to look at this potential investment in terms of the my ‘hurdle’ return and various value criteria that I require to qualify as a holding in my ‘Value’ portfolio, the one I discuss on this blog. First off, I usually look for a potential return of at least 100%-200% over a 2 to 3 year horizon. It is almost immediately apparent that Rouse would not qualify for a ‘value’ holding. But I do have an income portfolio for which it might be appropriate; For that portfolio I’m looking for an investment with a 15-20% annual return, low risk and a good margin of safety over an investment time horizon of 3 to 5 years. Let’s take a back of the envelope look at the financials to get some idea whether it might be attractive. I’ll use FFO as a surrogate for distributable cash flow and assume that Rouse will indeed qualify as a REIT. In the first 9 months of 2011 Rouse generated $36.8 million of FFO. If we extrapolate this for the entire 2011 year we get an annual FFO of around $49 million. With the current number of shares outstanding (pre rights offering) that equates to $1.38 per share. Post rights offering the equivalent FFO per share would be $1.04.

So what should I be will to pay for shares of Rouse? If I viewed Rouse in a very simplified way as a series of fixed cash flows equal to last year’s FFO, a kind of bond with no maturity, it would be easy to value. However, the rights issue introduces a complicating factor. The funds from the rights issue may be necessary to support the existing cash flows (i.e. maintenance spending not resulting in additional cash flows), they may be used to purchase additional properties with similar cash flow characteristics (and levered at the same ratio as current equity), or they may be used for some combination of the two. Set out below is a matrix showing hurdle returns in the left column with corresponding target purchase prices under these scenarios assuming all else remains equal (hardly a realistic assumption!). The first data column corresponds to the current status before the rights offering. The ‘low’ post-rights column assumes the incremental funds are needed for maintenance (i.e. don’t generate additional returns) while the ‘high’ column assumes that the funds from the rights offering are invested in real estate similar to what is currently owned and levered similarly. Without any better indications and because of my limited knowledge (have I said that enough?) I will be looking at the medium scenario for my target.

RSE Target price matrix
(in millions except share prices)		2011 FY est
		pre rights	post rights
			low	medium	high
FFO		$49.1	$49.1	$58.8	$68.5
Shares outstanding		35.52	47.36	47.36	47.36
FFO/share		$1.38	$1.04	$1.24	$1.45
Target   share price with:
10% return		$13.81	$10.37	$12.42	$14.47
12.5% return		$11.05	$8.29	$9.94	$11.58
15% return		$9.21	$6.91	$8.28	$9.65

The model I’ve described above is, of course, far too simplistic to really value the company. But it does provide a framework that we might begin with and rejigger according to what we think might actually happen. For example, don’t we expect FFO to increase at least with inflation? Don’t we anticipate that macroeconomic events will have an impact on FFO? That is, won’t rental fees increase or decrease depending on overall economic variation (expansion or contraction of the economy) and occupancy rates as well? Then there is the question of management and added value; given these and other variables, won’t the ability of management to juggle these various factors prove most important in determining the value (and thus the cash flows emanating from it) of the properties? So the above matrix is a first step. Now you have to plug in some subjective values using your own assumptions. If you use the matrix above at all, use it judiciously.

I, myself, have a number of questions about Rouse. For example, if, to qualify as a REIT, a company cannot have highly concentrated ownership (defined as the top 5 shareholders owning more than 50% of the equity) how will Rouse qualify when Brookfield alone will own over 50% of the equity following the rights offering? Maybe someone out there with more real estate investment knowledge than me (that should be most of you) has an insight into this. Another question might be whether the current debt/equity leverage ratio of about 2.5:1 is appropriate, to high or too low? An answer to that might shed some light onto what will be done with the right offering proceeds. And I have a whole bunch more questions!

In sum, because of my lack of expertise in the real estate sector, I’ll need Mr. Market to offer me shares in Rouse at a truly bargain basement level. Until then I guess I’ll just practice my patience.