Description

COMPANY OVERVIEW

American Financial Realty Trust is a self-managed, self-administered real estate investment trust (REIT) focused on acquiring and operating properties leased to regulated financial institutions. The Company started operations in 1996 and completed its equity IPO on June 30, 2003. AFR owns a diverse portfolio of class-A office space and high-quality retail branch locations leased to accredited financial institutions, including small, medium, regional and major national banks and insurance companies. All leases are triple, quad or bond-net leases, which means that AFR does not pay for taxes, operating expenses or [in most cases] capital improvements. These leases are typically 10 to 20 years in duration (average is 13.4 years).

AFR tries to provide its client financial institutions with “operational flexibility and reduced real estate exposure.” The Company is attempting to become the “preferred landlord of leading banks and other financial institutions through the development of mutually beneficial relationships.” To do this, AFR offers “flexible acquisition structures and lease terms.” The three acquisition structures are as follows:

Sale Leaseback Transactions - Acquire properties and lease them back to the seller pursuant to a triple net or bond net lease, under which the rent is based largely upon the property’s purchase price and the tenant’s credit;

Formulated Price Contracts - Acquire fee or assume leasehold interests in surplus bank branches at a formulated price… based on the fair market value of the property as determined through an independent appraisal… with a negotiated discount; and

Specifically Tailored Transactions - Typically related to the acquisition of office buildings and often include a sale and partial leaseback with the seller, applying leasing and pricing structures that are tailored to meet the seller’s specific needs.


STRATEGY AND PHILOSOPHY:

The Company has spent the last seven years honing its strategy. The strategy focuses on the following:

1. Only buy properties from accredited financial institutions, and dispose of any properties where the majority tenant is not a financial institution. Bank real estate typically consists of class-A office space and prime retail space for its branches. Excess branches can be either re-let to other banks or sold off to fast food, drugstore, video rental and other chains.
2. Develop deep relationships with their bank “clients” and become the bank industry’s clearinghouse for selling, leasing and in some cases buying real estate.
3. Move aggressively to achieve critical mass in portfolio size and acquisition flexibility – thus adding value to their client financial institutions.
4. Acquire entire portfolios at below market values and leaseback occupied space at below market rents – while maintaining an adequate return. Then use their expertise in re-leasing the vacant space to increase earnings.
5. Mitigate credit risk through:
a. Tenant diversification – over time, the Company will diversify its client base
b. Geographic Diversification – the company’s properties are in 28 states and Washington, D.C.
c. Focus on high-credit-quality tenants
d. Diversified set of contracts and financing options leads to stable risk-adjusted returns
i. The portfolio consists typically of long-term triple-net or bond-net leases with high credit quality tenants (over 85% and 82% respectively)
ii. There is a long-term date for the typical lease termination of 13.8 years
iii. The mix of different deals gives them stable income plus excess property that enhances their overall returns.
iv. Match the termination of leases with the debt terms
v. Amortize debt rapidly – but leave balloon payments to the end of the leases


MARKET AND MARKETING: WHY BANKS WILL SELL TO AND LEASE FROM AFR

Market Size: According to the FDIC, banks hold approximately $92.5 billion in real estate – at book value – including about 78,000 branches. The Company estimates that, in total, banks occupy (including leased and owned) between $200 and $250 billion of real estate. This consists typically of class A office space, bank branches in high-trafficked retail areas, as well as some back-office space in less desirable locations. Historically, most financial institutions (and corporations for that matter) have owned their real estate, and typically do a fine job of managing their immediate real estate needs; however, due to corporate restructurings, mergers, etc., they often find themselves with excess real estate – which they are notoriously poor at managing.

AFR’s Value Proposition to Financial Institutions:

1. Earnings Boost: For local, regional and mid-sized banks, freeing up the excess capital previously buried in their real estate provides additional tier one capital against which they can borrow and lend – providing significant returns on capital. For all banks, particularly the larger banks such as Bank of America (BAC) and Citibank (C), it lowers the total cost of office space – both in real dollars as well as through the elimination of depreciation – and thus increases earnings. In other words, selling and leasing back their real estate increases earnings in three ways: reducing operating costs, reducing depreciation on fixed assets and freeing up capital for expansion by providing additional tier one capital.

Example – AFR’s recent acquisition of a portfolio of Bank of America (BAC) properties: In BAC’s sale/leaseback with AFR that occurred in June 2003, AFR estimates that BAC will save about $30 million per year of cash costs by not owning or managing that space. That savings increases net income by the same amount on a pre-tax basis. Multiplying the additional net income by their current P/E [of 11] implies that this particular transaction created over $200m in additional market cap (assuming a 35% tax rate) – just from the cash savings. This is before depreciation costs are added back and before the additional capital is freed up against which to lever up and lend. One can see why management would find AFR’s offering attractive.

2. Operational Flexibility – Organic Growth/Downsizing: As banks build their brands, grow their physical presence through branches, increase assets and extend their product offerings, they need to move quickly – either to downsize or upsize. Real estate management is not a core competency and often an expensive cost of doing business. By selling and leasing back their real estate holdings, banks no longer have the properties on their books and can either rapidly grow in new areas through leasing or leave areas by selling the [newly] vacant branches as part of a portfolio to AFR. In essence, the unused space ceases to be the bank’s “problem,” and they can sell their excess space at a near market rate. This is not only a competitive advantage for AFR, but a near necessity for the banks – which avoid write-downs on unused/sold space.

3. Operational Flexibility – Acquisitions: When banks acquire other banks [or merge], they often need to move rapidly to decide which real estate to keep and which to sell. Overlapping branches are disposed of and their presence in certain geographical areas is rapidly expanded. As in #2 above, AFR can provide the ability to dispose of excess space or grow rapidly at relatively low cost – purchasing branches on behalf of the banks and leasing it to them as well as leasing existing space – an ability that is growing rapidly. At this time, there are few other entities that can move as quickly and effectively as AFR can.

Essentially, AFR’s business model is premised on the fact that there are better ways for a bank to use capital than to bury it in capitalized and operating-related real estate costs.


COMPETITION AND COMPETITIVE ADVANTAGE

The company has a distinct competitive advantage and what I believe is a defensible and growing market leadership position. The advantages are the following:

1. First Mover Advantage: AFR is the only company of size that deals solely in bank office space and retail branches.
2. Flexibility of Deal Structure: The Company has a seven-year history of being able to dispose of the excess properties in its portfolio – which enables the Company to provide substantial flexibility in its deal structures with banks. This is something that most other investors cannot afford to do.
3. Discount to Market Value: The Company has been able to buy properties at lower prices than banks would demand of other purchasers. The reasons: (1) AFR will buy portfolios that include underperforming / vacant properties; and (2) the banks would rather trade a lower purchase price for lower rent – this does two things: (a) it lowers their rent expense and thus raises earnings – which in putting a multiple on increased on-going earnings creates a higher market cap and (b) creates less depreciation recapture.
4. Critical Mass: The rapidly growing size, breadth and depth of AFR’s portfolio provides it with a critical mass through which it can absorb and re-let underperforming properties and be a one-stop shop for banks looking to sell or lease additional office space or bank properties. In other words, the company is rapidly positioning itself as a clearinghouse for bank-related real estate needs.
5. Relationships: AFR already has deep relationships with Bank of America (which accounts for 60% of its business), Fleet [through the merger provides additional inventory of 19 million square feet], AIG, Wachovia, Key Bank, AIG, and other major bank property owners and is building its relationships with Citibank as well as other major and regional banks.

Competition & Potential Competition: One would expect competition to come from Equity Office or another Sam Zell entity, Goldman’s Whitehall, Morgan Stanley’s real estate group, Blackstone, Apollo, or another private equity group or “future” public real estate company. At this point, the company believes (and I agree) that this does not make sense for most, if not all, private equity funds in that it requires a level of managerial expertise that would require a separate entity as well as the ability to absorb underperforming properties. Of course, should AFR’s success continue unabated, other large players may very well enter the market, perhaps in a sizeable way. There will, of course, be smaller players as well. Lastly, there are third party owners/lessors like AFR. They include Pitney Bowes, and Dana, but none of those companies has purchased bank assets in over three years. At this point, the company has only pierced about 2% of the [owned] market encompassing over 17 million square feet – mostly in office space. Thus, even if there is future competition, there is plenty of room for AFR to grow.

PORTFOLIO SUMMARY

The company owns office space and bank branches. The total number of properties, square footage and other data are as follows:

Property Type # Owned Square Footage Square Footage Percent
Owned Leased Occupied
Branches 471 2,391,453 2,055,910 86.0%
Office Space 221 15,655,408 13,956,173 89.2%
Total 692 18,046,861 16,012,083 88.8%

Average Rent – Office Space $11.71
Average Rent – Branches $18.80
% of Contractual Base Rent
from Financial Insitutions 88.6%
% of Contractual Base Rent
from “A” Tenants 84.7%
Weighted Avg. Remaining
Lease Term (years) 13.4 years
Typical Cap Rate on a deal 8.5-8.7

[Refer to the AFR 3rd Quarter Supplemental Disclosure document at www.afrt.com for more information. It is on the home page as a pdf file]

GROWTH AND PIPELINE

I believe most analysts and investors are underestimating the size of the deal pipeline of this company. AFR has divided their transaction sizes into three categories: $1-75 million; $75-250 million; and $250 million+. The deal pipeline on the first two size ranges is quite full – as expected. But, the company has been surprised by the pipeline of $250 million+ deals – of which they currently have four – and only one of which is with an existing client. That is in addition to the BAC / Fleet merger as well as BAC’s own projections of the addition of 750 branches over the next five years.

Under self-imposed current capital constraints, the company could go to the outer limits of a roughly 2 to 1 debt to equity ratio by using about $200 million of current cash and between $800 million and $1 billion of debt. Currently, there are several properties that are unencumbered so they could raise additional cash by mortgaging current assets. This would enable them to avoid doing highly leveraged new transactions.

That does not, however, prevent the company from re-entering the capital markets, which it has said it will do on an opportunistic basis – i.e. when a major deal presents itself and when the current capital capacity has been used up.

I believe that AFR is highly likely to do at least one or two major deals in the next year, in addition to the three smaller deals already completed this quarter (at a cost of about $224 million). Management recently stated that the Company is talking with 153 midsize and large banks that should provide them with continuous deal flow. Additionally, the Company has a significant level of recently acquired vacant space that it will put to work in the near future. AFR estimates that the Company can take its occupancy rate up from about 88% to 95%. This would add between 6 and 10 cents to annual AFFO/share – the best measure for a REIT of free cash flow.

An additional “kicker” is that the increased occupancy creates greater cash flow, lower un-reimbursed building expense and additional leverage potential (due to the cash flow and implied value increase). Of course, this creates higher earnings and excess capital with which to acquire new properties.

AFR is on track, I believe, to double its real estate holdings in the next 12-18 months. The gating factors may be their capacity to re-let space and properly manage the growing portfolio, though management seems quite confident that they have the team in place to handle almost any reasonable amount of growth. Should the company double its size, I estimate that it would generate at least $2 per share of AFFO. For comparison, current trailing AFFO was over $24 million in the most recent quarter and should reach at least $26 to 27 million in this fourth quarter. Analysts’ expectations for 2004 is between $1.35 and $1.40 per share.


RISKS

The primary risks of this investment are as follows:

1. General Execution: The Company must be able to find new profitable portfolios, and acquire them in a cost effective and capital efficient manner.
2. Tenant Concentration: Currently, over 60% of the space AFR owns is leased by Bank of America. AFR plans to further diversify away from Bank of America over time. One caveat is the pipeline afforded by the BAC/Fleet merger. However, that still leaves Citibank, JPMorgan, Wachovia (which now accounts for 12% of the portfolio), Bank One, Key Bank and others that could sell AFR significant portfolios of real estate.
3. Continued Depressed Interest Rates: The current low interest rates invite competition as money is still flowing relatively freely into the real estate world seeking higher yield. On the other hand, higher short-term rates would in effect drive out much of the competition that uses variable rate debt and protect AFR. [The rise in interest rates in general helps AFR – eliminating competition. They expect to keep their spread between the cap rate and debt on new acquisitions at about 3% regardless of the environment.]
4. Financial Industry Credit Deterioration: The current low cost of mortgage debt the Company is paying when it purchases and / or refinances its properties is based on the triple, quad and bond net leases signed with high-credit banks. A lower credit rating of any of their current and future clients would stymie AFR’s growth rate by increasing its cost of funds. However, that would not hurt the current portfolio as the Company locks in its debt at the time of purchase and has matched its debt and lease durations. This is critical: AFR maintains an acceptable level of debt whose maturity is tied to the length of the cash flow that is covering it – i.e. the long-term leases signed with the financial institutions. To AFR, these leases are the equivalent of what DOS was to Microsoft when it was young -- they provide steady cash flows, allowing AFR to take on other risky projects such as renting vacant space, which can take a varying amount of time.
5. Leasing: The company’s ability to re-let vacant space. [Note that due to the Company’s low acquisition cost of vacant space, it can afford to re-lease space at sub-market rates.]
6. Tenant Quality and Capital Structure: The company could materially stray from its tenant quality standards and debt / equity ratios.


MANAGEMENT AND THE BOARD OF DIRECTORS

Management has an excellent track record of properly structuring transactions that are advantageous to both parties, and has put together an execution team that continues to find new deals, effectively lease or sell vacant space, and manage the properties. They are excellent at managing the balance sheet and allocating capital. They are further supported by an incredible board of directors, led by Lew Ranieri, that provides great banking and insurance industry contacts and ensures that the Company will not simply grow for growth’s sake, but rather grow profitably.


FINANCIALS

Below are two examples that illustrate how the numbers work and why the returns can be extremely compelling. The first is a straight sale/leaseback and the second a customized transaction. Then I will briefly discuss the overall portfolio and earnings power of the company. In support, the company has a great presentation on its home page at www.afrt.com that provides portions of the 10Q as well as a detailed analysis of the portfolio and AFFO.

Anatomy of two transactions:

1. A recent sale / leaseback contract on a fully occupied building with a high-credit tenant and little if any substantive long-term escalations. An example is the October 8, 2003 acquisition of a building with 263,000 square feet. The purchase price was $51.7 million ($6.9 million in cash and $44.8 million in assumed debt). The gross income is about $4.5m [8.7% cap rate] and the property cash flow after debt service is just over $2 million. The ROE is 29.5% and the ROIC is 3.9%. The debt termination date will approximate the lease-end date.

2. A typical sale / leaseback on a partially occupied building is one with a high-credit tenant that occupies most but not all of the building – what AFR deems a “Specifically Tailored Transaction.” For example, AFR might pay $100m for a building or portfolio of buildings that are 80% leased to Bank of America. BAC will have a long-term lease with renewals that provide few escalations – perhaps 1.5% every five years. However, BAC will pay $8.5m per year in rent [an 8.5% cap rate]. Obviously, this is based on the whole building and thus 20% of the building is essentially free to AFR. Let’s say for example that the building is paid for using 1/3 cash and 2/3 debt. The following chart shows the returns and how they can go from great to fantastic.

Purchase Price $ 100,000,000
Debt 67,000,000
Cash 33,000,000
Building size - in Square Feet 725,689
Cost per Square Foot $ 137.80
Rent per Square Foot - bank cost $ 11.71
Rental Income 8,500,000
Cap Rate 8.50%
Cost of Debt 5.50%
Interest payments 3,685,000
Net Cash Flow from Property 4,815,000
ROE 14.6%
ROIC 4.8%

At 95% [vs. 80% at purchase] leased -
assume market rate of $18 vs. $11.71 1,959,361
Revised Rental Income 10,459,361
Interest payments (unchanged) 3,685,000
Net Cash Flow from Property 6,334,361
ROE 20.5%
ROIC 6.8%

AFR’s Balance Sheet
This is an estimate of AFR’s balance sheet, adjusted for the three recent transactions:

Land and Property at book $1,793,489,000
Cash $244,000,000
Debt $1,045,000,000
Equity $1,011,000,000
Approximate shares out. 112,000,000

As for current debt levels, AFR’s Treasurer, Rob Delaney said on the Q3 conference call:

The debt portfolio is composed of 44 loans and debt issuances on 270 properties. Our variable-rate debt is minimal and composes less than 5% of our total outstanding debt. [emphasis added] Our exposure to rising interest rates and changes in tenant credit ratings is minimal, in that our funding costs are locked in at that time of issuance. The overwhelming majority of our debt is amortizing debt. Our view is that amortization fosters rational maturity schedules, which result in a dramatic reduction in liquidity risk. Our financing strategy is centered in match funding principles, stable returns, and value creation. It is also based on building relationships with the investing public and market participants.

The dividend is currently $1.00 per share annually, payable quarterly, a yield of 6.3% based on today’s price. The AFFO in Q3 was over $24 million though the gross payout was clearly higher [$.25 on about 110m shares = $27.5 million] The dividend had been set earlier in the quarter and the board opted to keep it at $.25 despite the fact that several deals closed at the end of the quarter – later than anticipated.

Under the current capital structure, and without re-tapping the equity capital markets, I believe that the company can increase its AFFO from today’s level of roughly $1 to at least $1.30 to $1.40 per share – depending on AFR’s ability to acquire new properties, decrease operating expenses at the building level and lease excess office space and branches [in a weak commercial leasing environment]. Should the company re-tap the equity markets and then use the proceeds to raise more debt, I believe AFR will raise its AFFO per share to over $1.60 by the end of next year. This started as a land grab for AFR; however, it seems that many potential bank-clients are pushing AFR to get deals done. One would think that in an increasing interest rate environment and thus lower mortgage origination market, many banks would do anything to drive down costs and increase earnings.

If you would like a copy of my full financial model, please contact me and I would be happy to forward it.


VALUATION AND CATALYSTS

The current valuation of $16 provides a yield of 6.3%, in line with other high-quality REITs. Obviously, an increase in interest rates may create a temporary cap on the stock price, but this would actually be a positive for the company in the long run. If the company increases its AFFO to $1.40 by the end of next year, and interest rates remain at current levels, I believe that the stock could move from its current $16 to at least $19 or $20 (a 14 multiple on $1.40 of AFFO or 15-16 multiple on a 1.25 dividend – similar to today’s multiple). Add the dividend return and the total return is 25-30%. What makes this even more attractive is the Company’s ability to grow at a high rate for many years.

Catalyst

Catalysts include:

1. Increased visibility of the company’s deal pipeline.
2. Execution of another major purchase.
3. The closing of the BAC/Fleet merger.
4. An additional equity offering and subsequent levering of the balance sheet.
5. Decreasing vacancy rates on the current portfolio – showing the Street that they can effectively lease or sell the greatly increased volume of vacant space profitably.