Thesis and Summary:

At current levels, we believe that Forest City Enterprises (NYSE: FCE.A) presents a compelling risk/reward profile. Specifically, we believe that FCE.A: 1) is cheap on an absolute basis; 2) is very cheap on a relative basis (with appropriate hedges liquid and easily borrowable); 3) possesses multiple catalysts that should unlock value and result in a re-rating of the shares.

Forest City is an owner and developer of diversified real estate assets. The Company’s assets are concentrated in ‘core’ urban markets such as New York City, Washington DC, Boston, and Los Angeles. Forest City also holds significant assets in ‘non-core’ markets, many of which are targets for divestiture.

Based on our analysis, Forest City trades at a ≈25.0% discount on an unlevered basis and a ≈47.0% discount on a levered basis to its average public comparables.

From a structural perspective, we believe that Forest City is mispriced for three reasons:

1)     Unlike the vast majority of income-producing Real Estate companies, Forest City is not structured as a REIT. Moreover, Forest City owns a significant amount of non-income producing development assets. Accordingly, traditional REIT investors tend to ignore Forest City.

2)     Many investors may view Forest City’s balance sheet as significantly levered.

3)     The valuation of Forest City’s operating assets is not readily apparent; rather, one must carve out and analyze Forest City’s development assets in order to arrive at a residual capital structure and earnings for the Company’s operating assets.

We regard the first reason for the mispricing as both artificial in nature and the primary reason the investment opportunity exists. [Note: Forest City, like REITs, pays effectively zero cash taxes so tax leakage does not explain the valuation difference.]

Regarding Forest City’s balance sheet: unlike most REITs, the vast majority of Forest City’s debt is non-recourse property level mortgage debt at similar leverage levels to private market real estate. Accordingly, we believe that Forest City has an appropriate capital structure.

At current levels, assuming a valuation for Forest City’s development assets at book value (which we believe is conservative), Forest City’s operating assets trade at a ≈7.10% NOI yield (fully burdened with corporate costs) and ≈11.4x post-CapEx Funds from Operations.

The average valuation for Office, Retail, and Multi-Family REITs is a 5.30% NOI yield (burdened with corporate costs) and 20.1x post-CapEx Funds from Operations. Our research indicates that Forest City’s operating assets are, by in large, high quality assets in markets with strong barriers to entry. In short, we believe the assets are higher quality than average real estate assets and thus deserve a premium.  Therefore, we believe that through Forest City we are acquiring higher than average quality real estate at a very substantial discount.

We believe that Forest City management recognizes the discount at which the stock trades and that management is taking appropriate steps towards remedying the discount. Specifically, the Company is intent on divesting assets in non-core markets and thereby further highlighting the quality of its portfolio. As part of this strategy, Forest City has already sold a significant number of assets at valuation levels substantially higher than implied by the stock price.

Management has also acknowledged the benefits of converting to a REIT structure. While we do not anticipate such a transformation in the near term, should Forest City’s valuation not improve over the next 12-18 months, we believe that management will seriously consider a conversion. Additionally, the depletion of NOLs may likely motivate a REIT conversion.

Asset Portfolio:

As referenced, FCE.A asset portfolio falls into two buckets:

1)     Operating assets – stabilized real estate generating substantial cash flow

2)     Development assets – non-cash flow producing real estate projects in various stages of development

The Company material does a very good job of presenting detailed information on the entire portfolio. In this write-up, we’ll provide some summary thoughts and structural ways to think about the situation. We are happy to discuss in more detail any questions related to the components of NAV in follow up Q&A.

High profile FCE.A properties include the New York Times Building, MetroTech Office Center, The Barclays Center, 8 Spruce Street, San Francisco Centre Mall, Atlantic Yards development, The Yards Development.

Using the information provided in both its 10K and Investor Presentations, we performed a rigorous bottom-up analysis of FCE.A’s properties. We split the portfolio by asset category and location, and used cap-rates derived from private market transactions based on those parameters to build a thorough NAV analysis.

The net operating income from Forest City’s operating assets is split approximately 35%/35%/30% between Office/Retail/Multi-Family. Approximately 80% of Office NOI is derived from the NYC, DC, and Boston markets and approximately 65% of Retail NOI is derived from the NYC, DC, LA, and San Francisco markets. Forest City’s Multi-Family assets are geographically more dispersed.

Development Properties:

We believe that Forest City's development assets possess significant value. Approximately 50% of the value of the development pipeline is represented by Atlantic Yards. Atlantic Yards is a 6,400 unit residential development in Brooklyn in the immediate vicinity of the Barclay’s Center (which Forest City developed and also has an ownership stake). Based on extensive discussions with Brooklyn property owners and developers, we believe the prospects for this project are very strong.

Valuation:

Salient points regarding FCE.A’s valuation and our valuation methodology for FCE.A are these:

1)     Our bottom-up private market based valuation for FCE.A results in a valuation of $26-$29/share (burdened with the ≈$1,000mmm [$4.50/share] negative impact of ‘Other’ and ‘Corporate expenses’ – see below).

2)     FCE.A’s valuation is dragged down by two negative operating lines: 1) the ‘Other’ line within FCE.A’s NAV/NOI schedule; 2) Corporate level operating expenses. Our ‘Fully burdened’ figures (which are the primary numbers we use for valuation purposes) include the negative impact of both ‘Other’ and ‘Corporate expenses’ at the same cap-rate at which we value FCE.A’s operating assets.

1. The ‘Other’ line within FCE.A’s NAV/NOI schedule includes two components: 1) the negative drag from properties in lease up; 2) expenses that are not allocated to any specific asset category.

                                  i.    We believe that capitalizing the negative drag from properties in lease up adds a level of conservatism to our valuation.

1. Despite many discussions with the Company, we are still unclear on how much development related costs is included in either the ‘Other’ or the ‘Corporate expenses’ line. Additionally, on both a consolidated and segment level basis, FCE.A’s margins are below peer levels. There are certain factors which explain a portion of the margin differential; however, a meaningful portion is not readily explained (again, despite discussions with the Company).  We believe there are development related costs embedded in these lines and therefore it is conservative to fully burden FCE.A’s numbers with both lines and additionally conservative to capitalize the negative impact of those lines at the same cap-rate we use to value the operating properties.
2. Every $10mm eliminated from the combined $85mm of costs adds an additional ≈$.75/share of value. Capitalizing the combined $85mm of costs at 10x rather than the cap-rate used for the operating properties adds an additional $1.25-$2.25/share of value.

3)     In all our valuation cases, we value FCE.A’s ‘Net development assets and other’ at TBV. Based on our research, we believe that FCE.A’s development assets, in aggregate, are most likely worth more than TBV. In particular, we believe there is upside to the TBV of Atlantic yards and the Yards. Conversely, we think there is most likely downside to the TBV valuation of Ridge Hill. Upside valuation could yield another $1-$2/share in value.

4)     Our NOI and FFO/AFFO figures for FCE.A are all based on either run-rate or LTM numbers; the figures used for peer valuation analysis are all based on either CY13 or NTM numbers.

Peer Valuations:

Additionally: FCE.A generates a fair amount of ‘Other income’ which is a combination of Interest income (associated with interest rate swaps) and tax credit income. For the LTM period, ‘Other income’ was ≈$48mm. We do not include any portion of ‘Other income’ in our recurring figures for FCE.A. Rather, based on discussions with the Company and making what we believe are conservative assumptions, we have performed an NPV analysis of the ‘Other income’ stream and arrive  at an NPV of $157.5mm or ≈$.71/share.

Unlevered Valuation:

At $18.00/share, FCE.A currently trades at a ≈7.10% fully burdened EBITDA yield and a ≈8.05% property level NOI yield.

Levered Valuation:

Excluding the tangible book value of FCE.A’s ‘Net development assets and other’ and the NPV of FCE.A’s ‘Interest and other income,’ the residual share price for FCE.A’s operating assets is $10.19.

On a fully burdened, pre-CapEx basis, FCE.A is generating $1.18/share in FFO. On a fully burdened, post-CapEx basis, FCE.A is generating $.89/share in AFFO. The respective multiples of 11.4x and 8.6x compares to respective peer multiples of 16.3x and 20.1x.

Note: a 5.0% increase in NOI, at stable cap-rates and FFO/AFFO multiples, results in a ≈10.5% increase in to intrinsic value.

Thoughts on Hedging:

We believe FCE.A is cheap on an absolute basis.

However, we also recognize and are sensitive to the relationship between cap-rates and interest rates and thus we must be mindful of the prospects for rising interest rates. Moreover, given the dramatic discount at which FCE.A trades to its publicly traded REIT peers and combined with the likelihood of a REIT conversion for FCE.A over the next 18-24 months, we believe that there is prudency in hedging some portion of an FCE.A long position with short positions in certain REITs.

Structural Thoughts and Catalysts:

FCE.A management has made clear their intention to continue to dispose of assets in non-core markets. In our view, the disposition of those assets positively impacts FCE.A in a number of ways:

1)     Streamlines and improves the overall quality of the portfolio – increasingly, FCE.A’s portfolio is comprised on A quality assets in A quality markets. As investors begin to realize the increasingly diminished role of non-core assets in FCE.A’s portfolio, the consolidated valuation at which FCE.A trades should improve.

2)     Exhaustion of NOLs – FCE.A currently pays no cash taxes due to NOLs on its books. Presently, ≈$200mm in NOLs remain. FCE.A’s non-core assets sales will exhaust the Company’s NOLs. FCE.A management has stated publicly that upon exhaustion of all NOLs, the Company will have to very seriously consider a REIT conversion so that it may continue to avoid paying cash taxes. It appears likely, depending on the pace of non-core asset sales, that FCE.A will have consumed its NOLs in the 2015 timeframe.

3)     Enables FCE.A to delever – FCE.A management has stated its desire to reduce total leverage (net-debt/EBITDA to 8-9x); disposing of non-core assets at cap-rates that imply a better valuation than where the stock is trading (despite the non-core assets deserving lower valuations than the consolidated entity) is a compelling way to delever.

In the near term, continued non-core asset dispositions, delivering, and stabilization of properties in lease up are likely to result in a reinstatement of dividend, about which FCE.A has spoken publicly. Cash return to shareholders should be a positive catalyst for the stock and perhaps enable the Company to attract more attention from REIT investors.

Earlier this year, FCE.A hired advisors to perform an Earnings & Profits Analysis. That is typical early step taken by a C-Corp that is evaluating a REIT conversion and indicates that the Company is laying the initial groundwork to pursue a conversion.

Risks:

-       Industry wide-real estate valuation levels are a function of  absolute interest rate levels and credit spreads (in addition to any geographic or property specific risks)

-       Risks on certain development projects: Ridge Hill has struggled in lease up and FCE.A plans to invest substantial capital in Atlantic Yards

-       Corporate governance – the founding families control 55% of the voting shares; however, the Board of Directors does now have independent members