Description

Overview

Equity Commonwealth (EQC) is an office REIT with ~65% of the market cap in net cash, trading at a 20% discount to liquidation value.  EQC is chaired by Sam Zell and we believe a transformational event (either material acquisition or liquidation) is very likely within a year.  With the stock currently trading at a mid-9% forward cap rate and nearly $20 in net cash, we believe this presents a very attractive risk / reward to play into an event.  

Assets

EQC was written up by jso1123 in Jan 2015 for further background, and was formerly Commonwealth REIT when Corvex removed RMR prior to Zell’s involvement.  Since then, new management has executed a plan to dramatically transform the portfolio, shrinking it from ~155 properties with varying use and geographical characteristics to 13 CBD and suburban office sites and 2 industrial/flex properties, predominantly in attractive markets.

Strategic alternatives

This process has left the Company with $3 billion of cash sitting on the balance sheet (and close to a billion in additional liquidity).

To put that cash to work, management has been upfront with shareholders that they have taken and continue to look at a number of potential large deals in the office space, but have passed thus far due to valuation.  From the 4Q call in February:

“We remain focused on identifying attractive opportunities to invest in order to create superior returns for shareholders over the long term. That said, our strategy will be informed by market conditions. While the real estate investment sale market has softened somewhat in the past two years, pricing remained stout by historical standards. Cap rates and expected IRRs are low. Prices per pound are high relative to replacement costs. Pricing environment today for high-quality assets does not, in our view, lend itself to achieving superior results, and as a result we are being patient.”

“Well, we have looked at a variety of different asset class trying to find opportunity. We also are really focused on office and office-related opportunities. And I would say your comment is right that we view pricing across the board as pretty strong and not conducive to a great entry point. With respect to office, we have looked at opportunities that despite the overall market being strong, we have thought there might be an opportunity given complexity or given other challenges that the assets or the entities were facing might create an opportunity and we've invested a good bit of time and effort in pursuing those deals.”

It surfaced last November that EQC was snooping around Forest City as a potential use of cash: https://www.reuters.com/article/us-forestcity-m-a-equitycommonwealth-exc/exclusive-equity-commonwealth-approaches-forest-city-about-merging-sources-idUSKBN1DA2ZW

The Company has also been candid about what will happen if they can’t find a deal:

“We have a goal to deploy the capital and invest, but market conditions will dictate whether we can do that. And if we're unable to do that, most likely next year we'll focus on the most efficient highest value way to exit.”

We believe there is additional incentive for the company to act sooner rather than later, as after their recent sales of large assets in Chicago and Philadelphia close, the Company will have exhausted its NOL.  While as a REIT, they can simply start paying dividends on gains on any additional dispositions, the rest of the sales would be less tax efficient and the “war chest” that the company has built is unlikely to grow materially further given the required dividends from taxable gains.      

Why the discount exists

• Volatile financials – given the rapid pace of selling assets over the last 3 years, it has been challenging to model the EQC portfolio with any precision given the goalposts/portfolio change every quarter.  We believe the uncertainty around forecasting and optics of shrinking NOI and FFO have weighed on the stock (headline NOI is down 34% in 2017 and FFO down 20% YoY)

• Bloated G&A skews earnings potential – the company has maintained $45m-$50m of corporate G&A, which is higher than comparable office REITs with portfolios multiples the size of EQC.  The Company has maintained the expenses for the flexibility to explore and execute a transformative deal, however as stated above, the clock is ticking and shareholders are frustrated with the ongoing drag

• Inefficient capital structure – as the portfolio transformation has occurred, the balance sheet has increasingly become more net cash, which prevents the Company from generating returns equivalent to its peers given the suboptimal capital structure

• Relatively underfollowed – only a handful of equity analysts cover EQC with minimal bulge bracket coverage

Valuation

Even after adjusting for the recent material assets sales in Chicago and Philly (which was held for sale), we believe EQC can generate nearly the same cash SSNOI that it generated in 4Q’17 a year from now in 4Q’18 assuming the current asset base remains intact.  Based on noted cap rates, 1600 Market Street in Philly and 600 West Chicago were lower margin properties for EQC and 600 West also contributed nearly half of the free rent on the books in 4Q17, both of which will result in more efficient NOI conversion after the disposals.

The company will also benefit in 2018 from materially lower sq footage rolling off than in previous years.  Taking all this into account, the like-for-like portfolio should grow nicely in 2018, and management has indicated that they are well positioned to increase occupancy throughout 2018, which should further improve margins.  Our pro forma assumptions removing the recent asset sales are as follows:

Given those assumptions, we can look at what the portfolio is worth across a range of cap rates:

Public office REIT comps are generally trading in the 6-7% range currently (vs. EQC at ~9.5%), and we believe the portfolio in a control transaction for this portfolio would likely garner a valuation in or better than that range if management chose to liquidate.    

Additionally, in the Company’s 2 best markets, Bellevue and Austin, there are upside opportunities for the portfolio’s current earnings potential:

• At Research Park in Austin, the Company has 70 unutilized acres in a 177 acre complex near Apples’s 38 acre complex.  Flextronics has a lease expiring in 2029 that will provide cash flow on the property, but there is significant upside in a repurposing of that entire property in an attractive area of Austin

• Company owns >$1bn of development rights in Bellevue

• Repricing of 427k sq ft in Bellevue (where the pricing environment has been very favorable for landlords) when Expedia vacates in 2019

Risks

• Rates – trading on a daily basis is predominantly driven by rates and REIT indices, however there are multiple ways to hedge out this exposure

• Company makes a bad acquisition – we believe this management team has shown to be prudent and Zell has a strong track record, but there is always risk they do a bad deal, one that is misunderstood, or something tax inefficient

• Nothing happens – the stock may not generate meaningful alpha and may trade in line with your rate/REIT hedge if the Company fails to find anything to do with its cash

With a material cash position and significant valuation discount to peers, we believe the fundamental downside (other than rates, which can be hedged) of an investment in EQC is low and provides optionality to play either a liquidation of the remaining assets at a premium or an accretive deal by a capital allocator with a strong track record of value creation.

Catalyst

Catalysts

• Continued one off asset sales at accretive cap rates

• Transformative deal (acquisition or liquidation)

• Improvement in occupancy and margins

• Company resumes buying back stock