Description

With $3.4 billion in cash ($28 per share), practically no debt, four legacy office properties, and chaired by Sam Zell (one of the best real estate investors of his generation), Equity Commonwealth is ideally positioned to capitalize on post-Covid commercial real estate opportunities.

Equity Commonwealth (EQC) is a real estate investment trust that, for most of its history, owned and operated United States office properties.  EQC has been written up three times on VIC since Zell and his team assumed full operational control of EQC in 2014.  None of the theses worked out precisely as pitched.  However, each pitch ultimately rested on the contention that Zell-led management would be owner-oriented and responsible stewards of shareholder capital, a contention fully borne out by subsequent events.  At December 31, 2014, EQC owned 156 properties and had $340 million in cash, $2.2 billion in debt, and $385 million in preferred equity ahead of the common.  In the five-plus years since, management improved property operations, sold properties for attractive prices, paid down debt and preferred equity, and repurchased common stock when pricing was attractive.  Roll forward to today, EQC has four properties, $25 million in debt, $123 million in preferred equity, and $3.4 billion in cash while having paid out $6 per share in special dividends over the last two years.  Management has been patient, rational, competent, and owner-oriented.

Whatever the investment thesis in the past, the thesis now is simple – Sam Zell and his team with $3.4 billion in cash and an acquisition and operating platform poised to capitalize on the commercial real estate opportunities arising in a post-Covid world.

Uncertainty and Potential Dislocations.*  While the range of possible outcomes with respect to the Covid-19 pandemic has narrowed significantly since March, the future course of the pandemic remains uncertain.  Partly because of the continued uncertainty regarding the course of the pandemic (and regarding the response of governmental authorities and the behavioral response of the public independent of governmental action or inaction), and partly for other reasons, the range of possible outcomes for the economy is still extremely wide.  A sampler of open questions the answers to which could negatively affect the economy:  Will there be a second wave of the pandemic in the autumn coinciding with flu season; if a second wave occurs, will there be another round of government-imposed shutdowns and/or a behavioral response creating shutdown-like economics even in the absence of government mandates; what will be the effect of the expiration of enhanced unemployment insurance at the end of July; how quickly will hiring rebound (will unemployment be above or below 10% in December 2020); will there be a wave of small business bankruptcies and what effect would that have on the larger economy; to what extent and how quickly will cap-ex recover; what will be the effect of enormous state and local budget deficits and the (possible) resulting large declines in state and local government spending and employment; will global trade flows be permanently altered; will global supply chains be made more redundant and therefore less efficient; etc.

With respect to commercial real estate, in addition to the typical effects of an economic recession on real estate operations, profitability, and valuations (e.g., tenant defaults, vacancies, reduced rental rates, tightened loan underwriting), there may be more specific Covid-related consequences.  Again, a sampler of open questions (without touching on retail real estate – there is plenty of VIC and non-VIC commentary on the ongoing and now exacerbated retail apocalypse):  Will "working from home" become a sustained feature, permanently reducing the demand for corporate office space; conversely, will the perceived need for more distancing result in office tenants requiring more square feet per worker; will the current flight from urban cores to the suburbs and exurbs be durable, further reducing the demand for CBD office space and/or shifting demand to suburban office space; likewise will the flight from the urban core permanently reduce demand for urban multi-family housing, shifting demand to suburban and exurban SFR (whether owned or rented); urban or not, is there reduced demand for multi-family in general because of a generalized preference for space; how do changes in global trade and supply chains affect and shift demand for industrial real estate; etc.

*Caveat.  The thesis requires believing that the range of possible outcomes includes a not-brief recession with sustained elevated unemployment, rolling small business failures, and knock-on effects causing distress in other parts of the economy, which in turn leads to economy-led and pandemic-influenced dislocations and opportunities in commercial real estate.  As noted above, I believe the range of possible outcomes for the economy in general and commercial real estate in particular is still quite wide, and I don’t have a high degree of confidence in predicting any particular outcome.  However, for those that are highly confident that the coronavirus is fading away and will soon have negligible ongoing effects on behavior and the economy, and that in 2021 the overall economy and corporate profits will be as good as (or better than) they were in 2019 (except with higher asset prices because lower discount rates), I expect EQC will be a hard pass.

Acquisition Targets and Criteria.  Management has been forthcoming about its investment criteria and possible investment targets on earnings calls and at investor conferences, and I recommend that readers review recent transcripts.  That said, a summary:

• Management's wish list includes assets with cash flows that can be financed well (obviously not a unique view); long-term demand fundamentals that favor the asset class; assets with misunderstood characteristics that result in mispricing; and assets or businesses with operational challenges as management believes that provides them an edge.

• Management is not looking to reprise its CommonWealth REIT/Equity Commonwealth experience of buying an office portfolio at a discount and rationalizing it and selling it down.  Rather, management's stated goal is buy something with solid underlying business fundamentals and grow it into a long-term sustainable business.

• Although management will be focused primarily on the long-term business fundamentals of targeted acquisitions, I suspect that EQC is unlikely to stray from the consistent mantra of Zell's career, which is to buy below replacement cost.

• According to management, EQC will not compete with Equity Residential or Equity LifeStyle Properties, which rules out direct investments in multi-family and manufactured housing.  However, management has expressed openness to joint ventures; thus, it is not inconceivable that EQC could partner with Equity Residential if a sufficiently attractive opportunity presented itself.

• Specific targets include traditional office REITs trading at discounts to NAV, related sectors such as medical office and laboratory space, and industrial real estate.

• Pre-Covid, management ruled out investments in retail and hospitality.  Post-Covid, nothing is "redlined" and management is willing to look at anything that makes sense.  That said, retail is not management's first choice and may still not even be management's last choice.

• As alluded to above, management is open to partnering with others if it makes sense, while remaining cognizant that the public real estate markets value simplicity.

• Regarding timing, management in early May expressed their view that it is still early days and that it is probably months, if not quarters, before actionable opportunities are available.  They are nonetheless actively engaged, looking at a variety of opportunities, and prepared to act appropriately if something arises sooner.

Valuation.  EQC has $3.4 billion in cash and owns four legacy office properties (a 695,000 sq. ft. building in Denver, a 440,000 sq. ft. property and a 176,000 sq. ft property in Austin, Texas, and a 196,000 sq. ft. building in Washington, D.C.).  The 176,000 sq. ft. Austin property is encumbered by a $25 million mortgage which matures January 2021; the remaining properties are owned free and clear and EQC carries no other debt.  EQC has $123 million of preferred stock ahead of the common.  EQC's enterprise value and the implied value of its four remaining property are as follows:

At the current stock price, the property portfolio is valued at $400 psf and at a cap rate of 5.8% – not particularly cheap.  But the thesis is not one of buying a portfolio cheap and waiting for management to unlock value; rather it is banking on management to make value-creating acquisitions in a dislocated environment.  The downside if no opportunities are found would be liquidation.  I estimate liquidation value at $29 per share valuing the portfolio at a 10% cap rate, or 7% downside from the current stock price.

*     *     *     *     *

Special Dividend.  EQC has sold three properties in 2020, generating over $400 million in taxable gains.  EQC also expects to generate a relatively modest amount of taxable income from operations in 2020.  Consequently, the company currently intends to distribute a special dividend for 2020; I expect that the dividend will range from $3.00 to $4.00 per share.

SG&A.  An ongoing critique of EQC's management during the period it has rationalized and sold down the company's portfolio is that SG&A expenses remained high in relation to the size of the portfolio.  When viewed in that context, SG&A has indeed been high, and is now considerably elevated.  However, I do not believe that elevated SG&A is intended as a management enrichment program.  Management has been forthright that they are maintaining a structure that can evaluate, acquire, integrate, and operate a potentially large acquisition.  Your mileage may vary, but I believe management deserves the benefit of the doubt.  In any event, at the 2019 run rate of $38.4 million per year, SG&A constitutes approximately 1% of EQC's market cap, and there's no 20% carry.

Risks.

The primary risk to the thesis is that no compelling opportunities arise or are recognized, and EQC as a consequence does not utilize its war chest to make any needle-moving value-enhancing acquisitions.  This risk is real.  While I believe the range of possible outcomes includes a material likelihood of a deep prolonged recession with knock-on opportunity-creating effects on commercial real estate (exacerbated by pandemic-specific effects), I am by no means certain of this.  However, I believe the downside in this case is limited to 5% to 10%.

Another risk is that EQC identifies and acts on or more opportunities, but is mistaken as to their attractiveness and/or botches execution of the acquisition, integration, and ongoing operations.  This risk is also real (not even the best investors are infallible and Sam "L.A. Times" Zell is no exception), but one I am willing to take.

Catalyst

One or more value-enhancing acquisitions.